FORM 10-K/A AROTECH CORPORATION · Restatement of Previously-Issued Financial Statements During our management’s review of our interim financial statements for the period ended

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UNITED STATESSECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDEDDECEMBER31, 2004.

OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM______ TO ______.

Commission File Number: 0-23336

AROTECH CORPORATION(Exact name of registrant as specified in its charter)

Delaware 95-4302784(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

354 Industry Drive, Auburn, Alabama 36830(Address of principal executive offices)

(Zip Code)

(334) 502-9001(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class Name of each exchange on which registeredNone

Not applicable

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01

par valueIndicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subjectto such filing requirements for the past 90 days:

Yes xx No oo

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not containedherein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by referencein Part III of this Form 10-K or any amendment to this Form 10-K.

o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes xx No ooThe aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant as of June 30, 2004 was approximately$128,605,410 (based on the last sale price of such stock on such date as reported by The Nasdaq National Market and assuming, for the purposeof this calculation only, that all of the registrant’s directors and executive officers are affiliates).

(Applicable only to corporate registrants) Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as ofthe latest practicable date:

80,103,668 as of 3/10/05

Documents incorporated by reference: None

Potential persons who are to respond to the collection of information contained in this form are not required to respond unless the form displays a currentlyvalid OMB control number.

PRELIMINARY NOTE

This amended annual report contains historical information and forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995with respect to our business, financial condition and results of operations. The words “estimate,”“project,”“intend,”“expect” and similar expressions are intended to identifyforward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those contemplatedin such forward-looking statements. Further, we operate in an industry sector where securities values may be volatile and may be influenced by economic and other factorsbeyond our control. In the context of the forward-looking information provided in this annual report and in other reports, please refer to the discussions of risk factors detailedin, as well as the other information contained in, our other filings with the Securities and Exchange Commission.

Electric Fuel® is a registered trademark and Arotech™ is a trademark of Arotech Corporation, formerly known as Electric Fuel Corporation. All company and productnames mentioned may be trademarks or registered trademarks of their respective holders. Unless otherwise indicated, “we,”“us,”“our” and similar terms refer to Arotech and itssubsidiaries.

PART II

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI-TION AND RESULTS OF OPERATION

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve inherentrisks and uncertainties. When used in this discussion, the words “believes,”“anticipated,”“expects,”“estimates” and similar expressions are intended to identify such forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results t o differ materially from those projected. Readers arecautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly release the result ofany revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those set forthelsewhere in this report. Please see “Risk Factors,” below, and in our other filings with the Securities and Exchange Commission.

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements contained in Item 8 of this report, and the notesthereto. We have rounded amounts reported here to the nearest thousand, unless such amounts are more than 1.0 million, in which event we have rounded such amounts to thenearest hundred thousand. General

We are a defense and security products and services company, engaged in three business areas: interactive simulation for military, law enforcement and commercialmarkets; batteries and charging systems for the military; and high-level armoring for military, paramilitary and commercial vehicles. Until September 17, 2003, we were knownas Electric Fuel Corporation. We operate in three business units:

Ø we develop, manufacture and market advanced hi-tech multimedia and interactive digital solutions for use-of-force and driving training of military, lawenforcement, security and other personnel, as well as offering security consulting and other services (our Simulation, Security and Consulting Division);

Ø we manufacture aviation armor and we utilize sophisticated lightweight materials and advanced engineering processes to armor vehicles (our Armoring

Division); and

Ø we manufacture and sell Zinc-Air and lithium batteries for defense and security products and other military applications and we pioneer advancements inZinc-Air battery technology for electric vehicles (our Battery and Power Systems Division).

During 2004, we acquired three new businesses: FAAC Corporation, located in Ann Arbor, Michigan, which provides simulators, systems engineering and software

products to the United States military, government and private industry (which we have placed in our Simulation and Security Division); Epsilor Electronic Industries, Ltd.,located in Dimona, Israel, which develops and sells rechargeable and primary lithium batteries and smart chargers to the military and to private industry in the Middle East,Europe and Asia (which we have placed in our Battery and Power Systems Division); and Armour of America, Incorporated, located in Los Angeles, California, whichmanufacturers aviation armor both for helicopters and for fixed wing aircraft, marine armor, personnel armor, armoring kits for military vehicles, fragmentation blankets and aunique ballistic/flotation vest (ArmourFloat) that is U.S. Coast Guard-certified, which we have placed in our Armor Division. Prior to the acquisition of FAAC and Epsilor, wewere organized into two divisions: Defense and Security Products (consisting of IES, MDT and MDT Armor), and Electric Fuel Batteries (consisting of EFL and EFB). Ourfinancial results for 2003 do not include the activities of FAAC, Epsilor or AoA and therefore are not directly comparable to our financial results for 2004.

Restatement of Previously-Issued Financial Statements

During our management’s review of our interim financial statements for the period ended September 30, 2004, we, after discussion with and based on a new and

revised review of accounting treatment by our independent auditors, conducted a comprehen-sive review of the re-pricing of warrants and grant of new warrants to certain ofour investors and others during the years 2004 and 2003. As a result of that review, we, upon recommendation of our management and with the approval of the AuditCommittee of our Board of Directors after discussion with our independent auditors, reconsidered the accounting related to these transactions and reclassified certain expensesas a deemed dividend, a non-cash item, instead of as general and administrative expenses due to the recognition of these transactions as capital transactions that should not beexpensed. These restatements did not affect our balance sheet, shareholders’ equity or cash flow statements. In addition and as a result of the remeasurement described above,we have reviewed assumptions used in the calculation of fair value of all warrants granted during the year 2003. As a result of this comprehensive review, we have decreasedgeneral and administrative expenses in the amount of $150,000, related to errors found in the valuation of warrants granted in the litigation settlement described in Note 14.f.6.of the Notes to Consolidated Financial Statements for the year ended December 31, 2004.

I n addition, during our management’s review of our interim financial statements for the period ended September 30, 2004, we also reviewed our calculation ofamortization of debt discount attributable to the beneficial conversion feature associated with our convertible debentures. As a result of this review, we found errors whichincreased our financial expenses in the amount of $568,000 for the year ended December 31, 2003. The errors were related to the amortization of debt discount attributable tothe warrants and the related convertible debentures, whereby we understated the amount of amortization for the year ended December 31, 2003 attributable to certain of theconvertible debentures.

Similar errors were also noted in our interim financial statements in the three-month period ended June 30, 2003, the nine-month period ended September 30, 2003,and the three- and six-month periods ended March 31 and June 30, 2004.

The impacts of these restatements with respect to the year ended December 31, 2003 are summarized below:

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Statement of Operations Data: For the Year ended December 31, 2003

PreviouslyReported Adjustment As Restated

General and administrative expenses $ 6,196,779 $ (338,903) $ 5,857,876 Operating loss 5,408,932 (338,903) 5,070,029 Financial expenses, net 3,470,459 568,250 4,038,709 Loss from continuing operations 9,118,684 229,347 9,348,031 Net loss 9,008,274 229,347 9,237,621

Deemed dividend to certain stockholders of common stock - 350,000 350,000 Net loss attributable to common stockholders $ 9,008,274 $ 579,347 $ 9,587,621

Basic and diluted net loss per share from continuing operations $ 0.23 $ 0.01 $ 0.24 Basic and diluted net loss per share $ 0.23 $ 0.02 $ 0.25

Balance Sheet Data: As of December 31, 2003


Other accounts payable and accrued expenses $ 4,180,411 $ (150,000) $ 4,030,411 Total current liabilities 6,859,752 (150,000) 6,709,752 Convertible debenture 881,944 568,250 1,450,194 Total long term liabilities 4,066,579 568,250 4,634,829 Additional paid in capital 135,891,316 (188,903) 135,702,413 Accumulated deficit (109,681,893) (229,347) (109,911,240)Total shareholders’ equity 22,044,127 (418,250) 21,625,877

Cash Flow Data: For the Year ended December 31, 2003


Net loss $ 9,008,274 $ 229,347 $ 9,237,621 Stock based compensation related to repricing of warrants granted to investors and the grant of new

warrants 388,403 (188,903) 199,500 Increase in other accounts payable and accrued expenses 1,827,668 (150,000) 1,677,668 Amortization of compensation related to beneficial conversion feature and warrants issued to holders

of convertible debentures 3,359,987 568,250 3,928,237

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Critical Accounting Policies

The preparation of financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure ofcontingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluateour estimates and judgments, including those related to revenue recognition, allowance for bad debts, inventory, contingencies and warranty reserves, impairment of intangibleassets and goodwill. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Under differentassumptions or conditions, actual results may differ from these estimates.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financialstatements.

Revenue Recognition

Significant management judgments and estimates must be made and used in connection with the recognition of revenue in any accounting period. Material differencesin the amount of revenue in any given period may result if these judgments or estimates prove to be incorrect or if management’s estimates change on the basis of developmentof the business or market conditions. Management judgments and estimates have been applied consistently and have been reliable historically.

A portion of our revenue is derived from license agreements that entail the customization of FAAC’s simulators to the customer’s specific requirements. Revenuesfrom initial license fees for such arrangements are recognized in accordance with Statement of Position 81-1 “Accounting for Performance of Construction - Type and CertainProduction - Type Contracts” based on the percentage of completion method over the period from signing of the license through to customer acceptance, as such simulatorsrequire significant modification or customization that takes time to complete. The percentage of completion is measured by monitoring progress using records of actual timeincurred to date in the project compared with the total estimated project requirement, which corresponds to the costs related to earned revenues. Estimates of total projectrequirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and a re reviewed and updated regularly bymanagement.

We believe that the use of the percentage of completion method is appropriate as we have the ability to make reasonably dependable estimates of the extent of progresstowards completion, contract revenues and contract costs. In addition, contracts executed include provisions that clearly specify the enforceable rights regarding services to beprovided and received by the parties to the contracts, the consideration to be exchanged and the manner and terms of settlement. In all cases we expect to perform ourcontractual obligations and our licensees are expected to satisfy their obligations under the contract. The complexity of the estimation process and the issues related to theassumptions, risks and uncertainties inherent with the application of the percentage of completion method of accounting affect the amounts of revenue and related expensesreported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, utilization and specification andtesting requirement changes.

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We account for our other revenues from IES simulators in accordance with the provisions of SOP 97-2, “Software Revenue Recognition,” issued by the American

Institute of Certified Public Accountants and as amended by SOP 98-4 and SOP 98-9 and related interpretations. We exercise judgment and use estimates in connection with thedetermination of the amount of software license and services revenues to be recognized in each accounting period.

We assess whether collection is probable at the time of the transaction based on a number of factors, including the customer’s past transaction history and creditworthiness. If we determine that the collection of the fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generallyupon the receipt of cash.

Allowance for Doubtful Accounts

We make judgments as to our ability to collect outstanding receivables and provide allowances for the portion of receivables when collection becomes doubtful.Provisions are made based upon a specific review of all significant outstanding receivables. In determining the provision, we analyze our historical collection experience andcurrent economic trends. We reassess these allowances each accounting period. Historically, our actual losses and credits have been consistent with these provisions. If actualpayment experience with our customers is different than our estimates, adjustments to these allowances may be necessary resulting in additional charges to our statement ofoperations.

Accounting for Income Taxes

Significant judgment is required in determining our worldwide income tax expense provision. In the ordinary course of a global business, there are many transactionsand calculations where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of cost reimbursement arrangements among related entities, theprocess of identifying items of revenue and expense that qualify for preferential tax treatment and segregation of foreign and domestic income and expense to avoid doubletaxation. Although we believe that our estimates are reasonable, the final tax outcome of these matters may be different than that which is reflected in our historical income taxprovisions and accruals. Such differences could have a material effect on our income tax provision and net income (loss) in the period in which such determination is made.

We have provided a valuation allowance on the majority of our net deferred tax assets, which includes federal and foreign net operating loss carryforwards, because ofthe uncertainty regarding their realization. Our accounting for deferred taxes under Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”(“Statement 109”), involves the evaluation of a number of factors concerning the realizability of our deferred tax assets. In concluding that a valuation allowance was required,we primarily considered such factors as our history of operating losses and expected future losses in certain jurisdictions and the nature of our deferred tax assets. The Companyand its subsidiaries provide valuation allowances in respect of deferred tax assets resulting principally from the carryforward of tax losses. Management currently believes thatit is more likely than not that the deferred tax regarding the carryforward of losses and certain accrued expenses will not be realized in the foreseeable future. The company doesnot provide for US Federal Income taxes on the undistributed earnings of its foreign subsidiaries because such earnings are re-invested and, in the opinion of management, willcontinue to be re-invested indefinitely.

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In addition, we operate within multiple taxing jurisdictions and may be subject to audits in these jurisdictions. These audits can involve complex issues that may require

an extended period of time for resolution. In management’s opinion, adequate provisions for income taxes have been made.

Inventories

Our policy for valuation of inventory and commitments to purchase inventory, including the determination of obsolete or excess inventory, requires us to perform adetailed assessment of inventory at each balance sheet date, which includes a review of, among other factors, an estimate of future demand for products within specific timehorizons, valuation of existing inventory, as well as product lifecycle and product development plans. The estimates of future demand that we use in the valuation of inventoryare the basis for our revenue forecast, which is also used for our short-term manufacturing plans. Inventory reserves are also provided to cover risks arising from slow-movingitems. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market valuebased on assumptions about future demand and market conditions. We may be required to record additional inventory write-down if actual market conditions are less favorablethan those projected by our management. For fiscal 2004, no significant changes were made to the underlying assumptions related to estimates of inventory valuation or themethodology applied.

Goodwill

Under Financial Accounting Standards Board Statement No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), goodwill and intangible assets deemed to haveindefinite lives are no longer amortized but are subject to annual impairment tests based on estimated fair value in accordance with SFAS 142.

In June 2004, we completed our annual impairment test and assessed the carrying value of goodwill as required by SFAS 142. The goodwill impairment test comparedthe carrying value of the Company’s reporting units with the fair value at that date. Because the market capitalization exceeded the carrying value significantly, no impairmentarose.

We determine fair value using discounted cash flow analysis. This type of analysis requires us to make assumptions and estimates regarding industry economic factorsand the profitability of future business strategies. It is our policy to conduct impairment testing based on our current business strategy in light of present industry and economicconditions, as well as future expectations. In assessing the recoverability of our goodwill, we may be required to make assumptions regarding estimated future cash flows andother factors to determine the fair value of the respective assets. This process is subjective and requires judgment at many points throughout the analysis. If our estimates or theirrelated assumptions change in subsequent periods or if actual cash flows are below our estimates, we may be required to record impairment charges for these assets notpreviously recorded.

Other Intangible Assets

Other intangible assets are amortized to the Statement of Operations over the period during which benefits are expected to accrue, currently estimated at two to tenyears.

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We recorded a $320,000 impairment charge in 2004 in respect of certain technology acquired from Bristlecone in 2003.

The determination of the value of such intangible assets requires us to make assumptions regarding future business conditions and operating results in order to estimate

future cash flows and other factors to determine the fair value of the respective assets. If these estimates or the related assumptions change in the future, we could be required torecord additional impairment charges.

Contingencies

We are from time to time involved in legal proceedings and other claims. We are required to assess the likelihood of any adverse judgments or outcomes to thesematters, as well as potential ranges of probable losses. We have not made any material changes in the accounting methodology used to establish our self-insured liabilitiesduring the past three fiscal years.

A determination of the amount of reserves required, if any, for any contingencies are made after careful analysis of each individual issue. The required reserves maychange due to future developments in each matter or changes in approach, such as a change in the settlement strategy in dealing with any contingencies, which may result inhigher net loss.

If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material.

Warranty Reserves

Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty periodis typically twelve months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For newproducts, the warranty reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product. Factorsthat may impact our warranty costs in the future include our reliance on our contract manufacturer to provide quality products and the fact that our products are complex andmay contain undetected defects, errors or failures in either the hardware or the software. Functional Currency

We consider the United States dollar to be the currency of the primary economic environment in which we and our Israeli subsidiary EFL operate and, therefore, bothwe and EFL have adopted and are using the United States dollar as our functional currency. Transactions and balances originally denominated in U.S. dollars are presented atthe original amounts. Gains and losses arising from non-dollar transactions and balances are included in net income.

The majority of financial transactions of our Israeli subsidiaries MDT and Epsilor is in New Israel Shekels (“NIS”) and a substantial portion of MDT’s and Epsilor’scosts is incurred in NIS. Management believes that the NIS is the functional currency of MDT and Epsilor. Accordingly, the financial statements of MDT and Epsilor have beentranslated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts havebeen translated using the average exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive loss inshareholders’ equity.

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Recent Developments

CECOM IDIQ Order

In March 2005 we received a new Firm Fixed Price, Indefinite Delivery, Indefinite Quantity (IDIQ) order from the U.S. Army’s Communications Electronic Command(CECOM) to supply up to $24 million in zinc-air batteries and adaptors to the Department of Defense over the next three years. Under the new contract, EFB will be enabled todeliver the BA-8180/U zinc-air battery and the three existing interface adapters. In addition, a new battery, the BA-8140/U, and four new adapters are included in this contractand have been ordered for First Article Testing (FAT). Executive Summary

The following executive summary includes discussion of our new subsidiaries, FAAC Incorporated, Epsilor Electronic Industries, Ltd. and Armour of AmericaIncorporated, that we purchased in 2004.

Divisions and Subsidiaries

We operate primarily as a holding company, through our various subsidiaries, which we have organized into three divisions. Our divisions and subsidiaries (all 100%owned, unless otherwise noted) are as follows:

Ø Our Simulation and Security Division, consisting of:

· FAAC Incorporated, located in Ann Arbor, Michigan, which provides simulators, systems engineering and software products to the UnitedStates military, government and private industry (“FAAC”); and

· IES Interactive Training, Inc., located in Littleton, Colorado, which provides specialized “use of force” training for police, security personnel and

the military (“IES”).

Ø Our Armor Division, consisting of:

· Armour of America, located in Los Angeles, California, which manufacturers ballistic and fragmentation armor kits for rotary and fixed wingaircraft, marine armor, personnel armor, military vehicles and architectural applications, including both the LEGUARD Tactical Leg Armor andthe Armourfloat Ballistic Floatation Device, which is a unique vest that is certified by the U.S. Coast Guard (“AoA”);

· MDT Protective Industries, Ltd., located in Lod, Israel, which specializes in using state-of-the-art lightweight ceramic materials, special ballistic

glass and advanced engineering processes to fully armor vans and SUVs, and is a leading supplier to the Israeli military, Israeli special forcesand special services (“MDT”) (75.5% owned); and

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· MDT Armor Corporation, located in Auburn, Alabama, which conducts MDT’s United States activities (“MDT Armor”) (88% owned).

Ø Our Battery and Power Systems Division, consisting of:

· Epsilor Electronic Industries, Ltd., located in Dimona, Israel (in Israel’s Negev desert area), which develops and sells rechargeable and primarylithium batteries and smart chargers to the military and to private industry in the Middle East, Europe and Asia (“Epsilor”);

· Electric Fuel Battery Corporation, located in Auburn, Alabama, which manufactures and sells Zinc-Air fuel sells, batteries and chargers for the

military, focusing on applications that demand high energy and light weight (“EFB”); and

· Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh, Israel, which produces water-activated lifejacket lights for commercial aviation and marineapplications, and which conducts our Electric Vehicle effort, focusing on obtaining and implementing demonstration projects in the U.S. andEurope, and on building broad industry partnerships that can lead to eventual commercialization of our Zinc-Air energy system for electricvehicles (“EFL”).

Overview of Results of Operations

We incurred significant operating losses for the years ended December 31, 2004, 2003 and 2002. While we expect to continue to derive revenues from the sale of

products that we manufacture and the services that we provide, there can be no assurance that we will be able to achieve or maintain profitability on a consistent basis.

During 2003 and 2004, we substantially increased our revenues and reduced our net loss, from $18.5 million in 2002 to $9.2 million in 2003 to $9.0 million in 2004.This was achieved through a combination of cost-cutting measures and increased revenues, particularly from the sale of Zinc-Air batteries to the military and from sales ofproducts manufactured by the subsidiaries we acquired in 2002 and 2004.

We succeeded during 2004 in moving Arotech to a positive cash flow situation, for the first time in our history. We are focused on continuing this success in 2005 andbeyond, and ultimately on achieving profitability. In this connection, we note that most of our business lines historically have had weaker first halves than second halves, andweaker first quarters than second quarters. We expect this to be the case for 2005 as well.

A portion of our operating loss during 2004 and 2003 arose as a result of non-cash charges. These charges were primarily related to our acquisitions, financings andissuances of restricted shares and options to employees. Because we anticipate continuing certain of these activities during 2005, we expect to continue to incur such non-cashcharges in the future.

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Acquisitions

In acquisition of subsidiaries, part of the purchase price is allocated to intangible assets and goodwill, Amortization of intangible assets related to acquisition of

subsidiaries is recorded based on the estimated expected life of the assets. Accordingly, for a period of time following an acquisition, we incur a non-cash charge related toamortization of intangible assets in the amount of a fraction (based on the useful life of the intangible assets) of the amount recorded as intangible assets. Such amortizationcharges will continue during 2005. We are required to review intangible assets for impairment whenever events or changes in circumstances indicate that carrying amount of theassets may not be recoverable. If we determine, through the impairment review process, that intangible asset has been impaired, we must record the impairment charge in ourstatement of operations.

In the case of goodwill, the assets recorded as goodwill are not amortized; instead, we are required to perform an annual impairment review. If we determine, throughthe impairment review process, that goodwill has been impaired, we must record the impairment charge in our statement of operations.

As a result of the application of the above accounting rule, we incurred non-cash charges for amortization of intangible assets and impairment in the amount of $2.8million during 2004. See “Critical Accounting Policies - Other Intangible Assets,” above.

Financings

The non-cash charges that relate to our financings occurred in connection with our issuance of convertible debentures with warrants, and in connection with ourrepricing of certain warrants and grants of new warrants. When we issue convertible debentures, we record a discount for a beneficial conversion feature that is amortized ratablyover the life of the debenture. When a debenture is converted, however, the entire remaining unamortized beneficial conversion feature expense is immediately recognized in thequarter in which the debenture is converted. Similarly, when we issue warrants in connection with convertible debentures, we record debt discount for financial expenses that isamortized ratably over the term of the convertible debentures; when the convertible debentures are converted, the entire remaining unamortized debt discount is immediatelyrecognized in the quarter in which the convertible debentures are converted. As and to the extent that our remaining convertible debentures are converted, we would incursimilar non-cash charges going forward.

As a result of the application of the above accounting rule, we incurred non-cash charges related to amortization of debt discount attributable to beneficial conversionfeature in the amount of $4.1 million during 2004.

Additionally, in an effort to improve our cash situation and our shareholders’ equity, and in order to reduce the number of our outstanding warrants, during 2003 and2004 we induced holders of certain of our warrants to exercise their warrants by lowering the exercise price of the warrants to approximately market value in exchange forimmediate exercise of such warrants, and by issuing to such investors a lower number of new warrants at a higher exercise price. Under such circumstances, we record a deemeddividend in an amount determined based upon the fair value of the new warrants. As and to the extent that we engage in similar warrant repricings and issuances in the future,we would incur similar non-cash charges.

As a result of the application of the above accounting rule, we recorded a deemed dividend related to warrants repricing and grant of new warrants in the amount of$3.3 million during 2004.

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Restricted Share and Option Issuances

During 2004, we issued restricted shares to certain of our employees. These shares were issued as stock bonuses, and are restricted for a period of two years from thedate of issuance. Relevant accounting rules provide that the aggregate amount of the difference between the purchase price of the restricted shares (in this case, generallyzero) and the market price of the shares on the date of grant is taken as a general and administrative expense, amortized over the life of the period of the restriction.

Additionally, during 2003 and 2004 we issued options to employees that were subject to shareholder approval of a new stock option plan. While the options wereissued at the market price of our stock on the respective dates of issuance, they were not considered by applicable accounting rules to have been finally issued until the dateshareholder approval for the new stock option plan was obtained. In the interim, the market price of our stock had risen, and thus the options were deemed to have been issuedat a below-market price. We were therefore required to take as a general and administrative expense the aggregate difference

As a result of the application of the above accounting rules, we incurred non-cash charges related to stock-based compensation in the amount of $884,000 during 2004.

Overview of Financial Condition and Operating Performance

We shut down our money-losing consumer battery operations and began acquiring new businesses in the defense and security field in 2002. Thereafter, weconcentrated on eliminating our operating deficit and moving Arotech to cash-flow positive operations, a goal we achieved for the first time in our history in the second half of2004. In order to do this, we focused on acquiring businesses with strong revenues and profitable operations.

In our Simulation and Security Division, revenues grew from approximately $8.0 million in 2003 to $21.5 million in 2004 (on a pro forma basis, assuming we hadowned all components of our Simulation and Security Division since January 1, 2003, revenues would have grown from approximately $17.9 million in 2003 to $21.5 millionin 2004). We attribute this to a number of substantial orders, such as orders from the U.S. Army and the Chicago Transit Authority. As of December 31, 2004, our backlog forour Simulation and Security Division totaled $12.7 million.

Our Armor Division had record revenues during 2004, with revenues growing from approximately $3.4 million in 2003 to $18.0 million in 2004 (on a pro forma basis,assuming we had owned all components of our Armor Division since January 1, 2003, revenues would have grown from approximately $10.9 million in 2003 to $29.2 millionin 2004). Much of this growth was attributable to armoring orders connected with the war in Iraq. As of December 31, 2004, our backlog for our Armor Division totaled $4.0million.

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In our Battery and Power Systems Division, revenues grew from approximately $5.9 million in 2003 to $10.5 million in 2004 (on a pro forma basis, assuming we had

owned all components of our Battery and Power Systems Division since January 1, 2003, revenues would have fallen from approximately $10.8 million in 2003 to $10.5million in 2004). As of December 31, 2004, our backlog for our Battery and Power Systems Division totaled $8.3 million. Results of Operations

Preliminary Note

Summary

Results of operations for the year ended December 31, 2004 include the results of FAAC, Epsilor and AoA for the periods following our acquisition of each suchcompany during 2004. However, the results of these subsidiaries were not included in our operating results for the year ended December 31, 2003. Accordingly, the followingyear-to-year comparisons should not necessarily be relied upon as indications of future performance.

Following is a table summarizing our results of operations for the years ended December 31, 2004 and 2003, after which we present a narrative discussion and analysis: Year Ended December 31, 2004 2003* Revenues:

Simulation and Security Division $ 21,464,406 $ 8,022,026 Armor Division 17,988,687 3,435,716 Battery and Power Systems Division 10,500,753 5,868,899

$ 49,953,846 $ 17,326,641 Cost of revenues:


$ 34,011,094 $ 11,087,840 Research and development expenses:

Simulation and Security Division $ 395,636 $ 132,615 Armor Division 17,065 84,186 Battery and Power Systems Division 1,318,678 836,607

$ 1,731,379 $ 1,053,408 Sales and marketing expenses:

Simulation and Security Division $ 3,185,001 $ 2,237,386 Armor Division 565,981 180,631 Battery and Power Systems Division 1,171,235 926,872 All Other - 187,747

$ 4,922,217 $ 3,532,636 General and administrative expenses:

Simulation and Security Division $ 2,852,969 $ 1,001,404 Armor Division 1,323,982 518,053 Battery and Power Systems Division 965,058 188,655 All Other 5,514,857 4,149,764

$ 10,656,866 $ 5,857,876

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Year Ended December 31, 2004 2003* Financial expense (income):

Simulation and Security Division $ 27,842 $ (119,750)Armor Division 13,503 (19,918)Battery and Power Systems Division 54,511 7,936 All Other 4,133,109 4,170,441

$ 4,228,965 $ 4,038,709 Tax expenses:

Simulation and Security Division $ 77,811 $ 30,130 Armor Division 134,949 363,173 Battery and Power Systems Division 320,878 - All Other 52,471 2,890

$ 586,109 $ 396,193 Amortization of intangible assets and impairment losses:

Simulation and Security Division $ 1,643,682 $ 720,410 Armor Division 661,914 144,500 Battery and Power Systems Division 509,239 -

$ 2,814,835 $ 864,910 Minority interest in loss (profit) of subsidiaries:

Simulation and Security Division $ - $ - Armor Division (44,694) 156,900 Battery and Power Systems Division - -

$ (44,694) $ 156,900 Loss from continuing operations:

Simulation and Security Division $ 1,541,775 $ 75,130 Armor Division (222,485) (299,559)Battery and Power Systems Division (661,166) (612,760)All Other (9,700,437) (8,510,842)

$ (9,042,313) $ (9,348,031)Income from discontinued operations:

Simulation and Security Division $ - $ - Armor Division - - Battery and Power Systems Division - 110,410

$ - $ 110,410 Net loss:

Simulation and Security Division $ 1,541,775 $ 75,130 Armor Division (222,485) (299,559)Battery and Power Systems Division (661,166) (502,350)All Other (9,700,437) (8,510,842)

$ (9,042,313) $ (9,237,621)

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Year Ended December 31, 2004 2003* Revenues:


$ 49,953,846 $ 17,326,641 Cost of revenues:


$ 34,011,094 $ 11,087,840 Research and development expenses:

Simulation and Security Division $ 395,636 $ 132,615 Armor Division 17,065 84,186 Battery and Power Systems Division 1,318,678 836,607

$ 1,731,379 $ 1,053,408 Sales and marketing expenses:

Simulation and Security Division $ 3,185,001 $ 2,237,386 Armor Division 565,981 180,631 Battery and Power Systems Division 1,171,235 926,872 All Other - 187,747

$ 4,922,217 $ 3,532,636 General and administrative expenses:

Simulation and Security Division $ 2,852,969 $ 1,001,404 Armor Division 1,323,982 518,053 Battery and Power Systems Division 965,058 188,655 All Other 5,514,857 4,149,764

$ 10,656,866 $ 5,857,876

* Restated (see Note 1.b. of Notes to Consolidated Financial Statements).

Fiscal Year 2004 compared to Fiscal Year 2003

Revenues. During 2004, we recognized revenues as follows:

Ø From the sale of interactive training systems and from the provision of warranty services in connection with such systems (FAAC and IES);

Ø From payments under armor contracts and for service and repair of armored vehicles (AoA and MDT);

Ø From the sale of batteries, chargers and adapters to the military, and under certain development contracts with the U.S. Army (EFB and Epsilor);

Ø From the sale of lifejacket lights (EFL); and

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Ø From subcontracting fees received in connection with Phase III of the United States Department of Transportation (DOT) electric bus program, which

began in October 2003 and was completed in March 2004. Phase IV of the DOT program, which began in October 2004, did not result in any revenuesduring 2004 (EFL).

Revenues from continuing operations for the year ended December 31, 2004 totaled $50.0 million, compared to $17.3 million for 2003, an increase of $32.6 million,

or 188%. This increase was primarily attributable to the following factors:

Ø Increased revenues from vehicle armoring; and

Ø Revenues generated by FAAC, Epsilor and AoA in 2004 that were not present in 2003.

These increases were offset to some extent by decreased revenues from sales of interactive use-of-force training systems and decreased revenues from sales o f ourZinc-Air military batteries.

In 2004, revenues were $21.5 million for the Simulation and Security Division (compared to $8.0 million in 2003, an increase of $13.4 million, or 168%, due primarilyto the added revenues from sales of driver training systems since we acquired FAAC (approximately $16.5 million), offset to some extent by decreased revenues from use-of-force training systems); $18.0 million for the Armor Division (compared to $3.4 million in 2003, an increase of $14.6 million, or 424%, due primarily to increased revenuesfrom vehicle armoring and to the added revenues from aircraft armoring since we acquired AoA); and $10.5 million for the Battery and Power Systems Division (compared to$5.9 million in 2003, a n increase of $4.6 million, or 79%, due primarily to the added revenues from sales of lithium batteries and chargers since we acquired Epsilor(approximately $5.3 million), offset to some extent by decreased revenues from our Zinc-Air military batteries).

Cost of revenues and gross profit. Cost of revenues totaled $34.0 million during 2004, compared to $11.1 million in 2003, an increase of $22.9 million, or 207%, dueto increased cost of goods sold, particularly in the Armor Division (partly as a result of our beginning to sell pre-armored vehicles in 2004, which requires us to purchasevehicles for pre-armoring) and in the Simulation and Security Division, as well as the inclusion of the cost of goods of FAAC, Epsilor and AoA in our results for 2004 but not2003.

Direct expenses for our three divisions during 2004 were $17.9 million for the Simulation and Security Division (compared to $7.3 million in 2003, an increase of$10.6 million, or 145%, due primarily to the addition of expenses associated with sales of driver training systems through FAAC (approximately $12.0 million), offset to someextent by decreased expenses associated with the sales of use-of-force training systems); $16.4 million for the Armor Division (compared to $3.6 million in 2003, an increase of$12.9 million, or 359%, due primarily to increased expenses associated with sales of vehicle armoring (a $12.1 million increase in 2004, including the expenses of purchasingvehicles for pre-armoring in 2004, which was not present in 2003), and to the addition beginning in August 2004 of expenses associated with sales of aircraft armoring throughour new subsidiary AoA); and $10.0 million for the Battery and Power Systems Division (compared to $5.9 million in 2003, an increase of $4.0 million, or 68%, due primarilyto the addition of expenses associated with sales of lithium batteries and chargers through our new Epsilor subsidiary ($4.2 million), offset to some extent by decreased expensesassociated with the sales of Zinc-Air military batteries).

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Gross profit was $15.9 million during 2004, compared to $6.2 million during 2003, an increase of $9.7 million, or 155%. This increase was the direct result of all

factors presented above, most notably the inclusion of FAAC, Epsilor and AoA in our results for 2004 ($10.2 million), as well as the increased revenues from vehicle armoring($1.6 million), offset to some extent by a decrease of $2.0 million in gross profit from IES.

Research and development expenses. Research and development expenses for 2004 were $1.7 million, compared to $1.1 million in 2003, an increase of $678,000, or64%. This increase was primarily the result of the inclusion of the research and development expenses of FAAC, Epsilor and AoA in our results in 2004 ($533,000) andincreased research and development expenses of EFL and EFB.

Sales and marketing expenses. Sales and marketing expenses for 2004 were $4.9 million, compared to $3.5 million in 2003, an increase of $1.4 million, or 39%. Thisincrease was primarily attributable to the inclusion of the sales and marketing expenses of FAAC, Epsilor and AoA in our results for 2004 ($2.0 million), offset to some extentby a decrease of $600,000 in expenses related to our military batteries and a decrease in sales and marketing expenses related to interactive use-of-force training.

General and administrative expenses. General and administrative expenses for 2004 were $10.7 million, compared to $5.9 million in 2003, an increase of $4.8million, or 82%. This increase was primarily attributable to the following factors:

Ø The inclusion of the general and administrative expenses of FAAC, Epsilor and AoA in our results for 2004 ($2.4 million);

Ø Expenses in 2004 in connection with grant of options and shares to employees that were not present in 2003 ($830,000);

Ø Costs associated with our compliance with Section 404 of the Sarbanes-Oxley Act of 2002 that were not present in 2003 ($150,000); and

Ø Increases in other general and administrative expenses, such as employee salaries and bonuses, travel expenses, audit fees, director fees, legal fees, andexpenses related to due diligence performed in connection to certain potential acquisitions, that were not present in 2003.

We are not anticipating a reduction in our general and administrative expenses in the coming year, and we expect that our travel expenses, audit fees, legal fees, and

due diligence expenses will continue or increase to the extent that we continue to pursue acquisitions in the future.

These increases were offset to some extent by:

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Ø Expenses in 2003 in connection with a litigation settlement agreement that were not present in 2004 ($700,000); and

Ø Amortization of legal and consulting expenses in 2003 in connection with our convertible debentures that were lower (by $260,000) than in 2004.

Financial expenses, net. Financial expense, net of interest income and exchange differentials, totaled approximately $4.2 million in 2004 compared to $4.0 million in

2003, an increase of $190,000, or 5%. This difference was due primarily to amortization of debt discount related to the issuance of convertible debentures and their conversion,as well as interest expenses related to those debentures.

Income taxes. We and certain of our subsidiaries incurred net operating losses during 2004 and, accordingly, we were not required to make any provision for incometaxes. With respect to some of our subsidiaries that operated at a net profit during 2004, we were able to offset federal taxes against our net operating loss carry forwards. Werecorded a total of $586,000 in tax expenses in 2004, with respect to certain of our subsidiaries that operated at a net profit during 2004 and we are not able to offset their taxesagainst our net operating loss carry forwards and with respect to state taxes. In 2003, tax expenses were recorded with respect to MDT’s taxable income. Out of the $586,000 taxexpense that we recorded in 2004, $84,000 was related to prior years and $(37,000) represented income from deferred taxes, net.

Amortization of intangible assets. Amortization of intangible assets totaled $2.8 million in 2004, compared to $865,000 in 2003, an increase of $1.9 million, or 225%,resulting from the inclusion of the amortization of the intangible assets of FAAC, Epsilor and AoA in our results in 2004 and impairment in the amount of $320,000 oftechnology previously purchased by IES from Bristlecone Technologies.

Net loss before deemed dividend of common stock to certain stockholders. Due to the factors cited above, we reported a net loss of $9.0 million in 2004, compared toa net loss of $9.2 million in 2003, a decrease of $195,000, or 2%.

Net loss after deemed dividend of common stock to certain stockholders was $12.4 million due to a deemed dividend of $3.3 million (see Notes 14.f.4. and 14.f.5. tothe financial statements) compared to $9.6 million in 2003, an increase of 2.8 million, or 29%.

Fiscal Year 2003 compared to Fiscal Year 2002

Revenues. During 2003, we (through our subsidiaries) recognized revenues as follows:

Ø IES recognized revenues from the sale of interactive use-of-force training systems and from the provision of warranty services in connection with suchsystems;

Ø MDT recognized revenues from payments under vehicle armoring contracts and for service and repair of armored vehicles;

Ø EFB recognized revenues from the sale of batteries and adapters to the military, and under certain development contracts with the U.S. Army;

Ø Arocon recognized revenues under consulting agreements; and

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Ø EFL recognized revenues from the sale of lifejacket lights and from subcontracting fees received in connection with Phase III of the United States

Department of Transportation (DOT) electric bus program, which began in October 2002 and was completed in March 2004. Phase IV of the DOTprogram, which began in October 2003, did not result in any revenues during 2003.

Revenues from continuing operations for the year ended December 31, 2003 totaled $17.3 million, compared to $6.4 million for 2002, an increase of $10.9 million, or

170%. This increase was primarily the result of increased sales attributable to IES and EFB, as well as the inclusion of IES and MDT in our results for the full year of 2003 butonly part of 2002.

In 2003, revenues were $8.0 million for the Simulation and Security Division (compared to $2.0 million in 2002, an increase of $6.0 million, or 305%, due primarily tothe inclusion of IES in our results for the full year of 2003 but only part of 2002), $5.9 million for the Battery and Power Systems Division (compared to $1.7 million in thecomparable period in 2002, an increase of $4.2 million, or 249%, due primarily to increased sales to the U.S. Army on the part of EFB), and $3.4 million for the Armor Division(compared to $2.7 million in 2002, an increase of $691,000, or 25%, due primarily to the inclusion of MDT in our results for the full year of 2003 but only part of 2002).

Cost of revenues and gross profit. Cost of revenues totaled $11.1 million during 2003, compared to $4.4 million in 2002, an increase of $6.7 million, or 151%, due toincreased cost of goods sold, particularly by IES and EFB, as well as the inclusion of IES and MDT in our results for the full year of 2003 but only part of 2002.

Direct expenses for our three divisions during 2003 were $7.3 million for the Simulation and Security Division (compared to $2.0 million in 2002, an increase of $5.3million, or 259%, due primarily to increased sales attributable to the inclusion of IES in our results for the full year of 2003 but only part of 2002), $5.9 million for the Batteryand Power Systems Division (compared to $3.1 million in the comparable period in 2002, an increase of $2.9 million, or 94%, due primarily to increased sales on the part ofEFB to the U.S. Army), and $3.6 million for the Armor Division (compared to $2.3 million in 2002, an increase of $1.3 million, or 55%, due primarily to the inclusion of MDTin our results for the full year of 2003 but only part of 2002).

Gross profit was $6.2 million during 2003, compared to $2.0 million during 2002, an increase of $4.3 million, or 214%. This increase was the direct result of all factorspresented above, most notably the increased sales of IES and EFB, as well as the inclusion of IES and MDT in our results for the full year of 2003 but only part of 2002. In2003, IES contributed $4.1 million to our gross profit, EFB contributed $1.6 million, and MDT contributed $833,000.

Research and development expenses. Research and development expenses for 2003 were $1.1 million, compared to $686,000 in 2002, an increase of $367,000, or54%. This increase was primarily because certain research and development personnel who had worked on the discontinued consumer battery operations during 2002 (theexpenses of which are not reflected in the 2002 number above) were reassigned to military battery research and development in 2003.

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Sales and marketing expenses. Sales and marketing expenses for 2003 were $3.5 million, compared to $1.3 million in 2002, an increase of $2.2 million, or 170%. This

increase was primarily attributable to the following factors:

Ø The inclusion of the sales and marketing expenses of IES and MDT in our results for the full year of 2003 but only part of 2002;

Ø An increase in IES’s sales activity during 2003, which resulted in both increased sales and increased sales and marketing expenses during 2003; and

Ø We incurred expenses for consultants in the amount of $810,000 in connection with our CECOM battery program with the U.S. Army and $345,000 inconnection with our security consulting business.

General and administrative expenses. General and administrative expenses for 2003 were $5.9 million, compared to $4.0 million in 2002, an increase of $1.8 million,

or 46%. This increase was primarily attributable to the following factors:

Ø The inclusion of the general and administrative expenses of IES and MDT in our results for the full year of 2003 but only part of 2002;

Ø Expenses in 2003 in connection with a litigation settlement agreement, in the amount of $714,000, that were not present in 2002;

Ø Expenses in 2003 in connection with warrant grants, in the amount of $199,500, that were not present in 2002;

Ø Legal and consulting expenses in 2003 in connection with our convertible debentures, in the amount of $484,000, that were not present in 2002; and

Ø Expenses in 2003 in connection with the start-up of our security consulting business in the United States and with the beginning of operations of MDTArmor, in the amount of $250,000, that were not present in 2002.

Financial income (expense). Financial expense totaled approximately $4.0 million in 2003 compared to financial income of $100,000 in 2002, an increase of $4.1

million. This increase was due primarily to amortization of compensation related to the issuance of convertible debentures issued in December 2002 and during 2003 in theamount of $3.9 million, and interest expenses related to those debentures in the amount of $376,000.

Tax expenses. We and our Israeli subsidiary EFL incurred net operating losses during 2003 and 2002 and, accordingly, we were not required to make any provision forincome taxes. MDT and IES had taxable income, and accordingly we were required to make provision for income taxes in the amount of $396,000 in 2003. We were able tooffset IES’s federal taxes against our loss carryforwards. In 2002 we did not accrue any tax expenses due to our belief that we would be able to utilize our loss carryforwardsagainst MDT’s taxable income, estimation was revised in 2003. Of the amount accrued in 2003, approximately $352,000 was accrued on account of income in 2002.

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Amortization of intangible assets and in-process research and development. Amortization of intangible assets totaled $865,000 in 2003, compared to $649,000 in

2002, an increase of $215,000, or 33%, resulting from amortization of these assets subsequent to our acquisition of IES and MDT in 2002. Of this $215,000 increase, $169,000was attributable to IES and $46,000 was attributable to MDT.

Loss from continuing operations. Due to the factors cited above, we reported a net loss from continuing operations of $9.3 million in 2003, compared to a net loss of$4.9 million in 2002, an increase of $4.4 million, or 90%.

Profit (loss) from discontinued operations. In the third quarter of 2002, we decided to discontinue operations relating to the retail sales of our consumer batteryproducts. Accordingly, all revenues and expenses related to this segment have been presented in our consolidated statements of operations for the years ended December 31,2003 and 2002 in an item entitled “Loss from discontinued opera-tions.”

Income from discontinued operations in 2003 was $110,000, compared to a loss of $13.6 million in 2002, a decrease of $13.7 million. This decrease was the result ofthe elimination of the losses from these discontinued operations beginning with the fourth quarter of 2002. The income from discontinued operations was primarily fromcancellation of past accruals made unnecessary by the closing of the discontinued operations.

Net loss before deemed dividend. Due to the factors cited above, we reported a net loss before deemed dividend of $9.2 million in 2003, compared to a net loss of$18.5 million in 2002, a decrease of $9.3 million, or 50%.

Net loss after deemed dividend of common stock to certain stockholders. Due to the factors cited above, we reported a net loss after deemed dividend of $9.6 millionin 2003, compared to a net loss of $18.5 million in 2002, a decrease of $8.9 million, or 48%. Liquidity and Capital Resources

As of December 31, 2004, we had $6.7 million in cash, $7.0 million in restricted collateral securities and restricted held-to-maturity securities due within one year, $4.0million in long-term restricted deposits, and $136,000 in available-for-sale marketable securities, as compared to at December 31, 2003, when we had $13.7 million in cash and$706,000 in restricted cash deposits due within one year. The decrease in cash was primarily the result of the costs of the acquisitions of FAAC, Epsilor and AoA, and workingcapital needed in our other segments.

We used available funds in 2004 primarily for acquisitions, sales and marketing, continued research and development expenditures, and other working capital needs.We increased our investment in fixed assets by $1.7 million during the year ended December 31, 2004, primarily in the Battery and Power Systems Division and in theSimulation and Security Division. Our net fixed assets amounted to $4.6 million as at year end.

Net cash used in operating activities for 2004 and 2003 was $852,000 and $3.3 million, respectively, a decrease of $2.5 million, or 75%. This decrease was primarilythe result of an increase in our adjusted net income in 2004 (net income in statement of operations less non-cash charges such as depreciation, amortization, non-cash financialexpenses and non-cash expenses related to options and warrants).

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Net cash used in investing activities for 2004 and 2003 was $50.5 million and $1.8 million, respectively, an increase of $48.7 million. This increase was primarily the

result of our investment in the acquisition of FAAC, Epsilor and AoA in 2004.

Net cash provided by financing activities for 2004 and 2003 was $44.4 million and $17.4 million, respectively, an increase of $27.0 million, or 156%. This increasewas primarily the result of higher amounts of funds raised through sales of our securities in 2004 compared to 2003.

During 2004, certain of our employees exercised options under our registered employee stock option plan. The proceeds to us from the exercised options wereapproximately $1.1 million.

We have approximately $5.5 million in long-term debt outstanding (not including accrued severance pay), of which $4.5 million was related to convertible debt(unamortized financial expenses related to the beneficial conversion feature o f these convertible debentures amounted to approximately $2.8 million at year end), andapproximately $13.7 million in short-term debt (not including trade payables and other accounts payable), of which $13.4 million relates to the earn-out provision in connectionwith our acquisition of FAAC.

Our debt agreements contain customary affirmative and negative operations covenants that limit the discretion of our management with respect to certain businessmatters and place restrictions on us, including obligations on our part to preserve and maintain our assets and restrictions on our ability to incur or guarantee debt, to merge withor sell our assets to another company, and to make significant capital expenditures without the consent of the debenture holders, as well as granting to our investors a right offirst refusal on any future financings, except for underwritten public offerings in excess of $30 million. We do not believe that this right of first refusal will materially limit ourability to undertake future financings.

Based o n our internal forecasts, we believe that our present cash position and anticipated cash flows from operations should be sufficient to satisfy our currentestimated cash requirements through at least the twelve months. This belief is based on certain assumptions that our management believes to be reasonable, some of which aresubject to the risk factors detailed below. Over the long term, we will need to become profitable, at least on a cash-flow basis, and maintain that profitability in order to avoidfuture capital requirements. Additionally, we would need to raise additional capital in order to fund any future acquisitions. Effective Corporate Tax Rate

We and certain of our subsidiaries incurred net operating losses during the years ended December 31, 2002, 2003 and 2004, and accordingly no provision for incometaxes was required. With respect to some of our U.S. subsidiaries that operated at a net profit during 2004, we were able to offset federal taxes against our net operating losscarryforward, which amounted to $23 million as of December 31, 2004. These subsidiaries are, however, subject to state taxes that cannot be offset against our net operatingloss carryforward. With respect to certain of our Israeli subsidiaries that operated at a net profit during 2004, we were unable to offset their taxes against our net operating losscarryforward, and we are therefore exposed to Israeli taxes, at a rate of up to 35% (less, in the case of companies that have “approved enterprise” status as discussed in Note 15to the Notes to Financial Statements).

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As of December 31, 2004, we had a U.S. net operating loss carryforward of approximately $23.0 million that is available to offset future taxable income under certain

circumstances, expiring primarily from 2009 through 2024, and foreign net operating and capital loss carryforwards of approximately $87.0 million, which a re availableindefinitely to offset future taxable income under certain circumstances. Contractual Obligations

The following table lists our contractual obligations and commitments as of December 31, 2004, not including trade payables and other accounts payable:

Payment Due by Period

Contractual Obligations Total

Less Than 1Year 1-3 Years 3-5 Years

More than 5Years

Long-term debt* $ 5,558,391 $ - $ 5,558,391 $ - $ - Short-term debt** $ 13,766,677 $ 13,766,677 $ - $ - $ - Operating lease obligations $ 1,427,965 $ 762,636 $ 641,017 $ 24,312 $ - Severance obligations*** $ 1,642,801 $ 223,333 $ 1,240,871 $ - $ 178,597

* Includes convertible debentures in the gross amount of $4,537,500. Unamortized financial expenses related to the beneficial conversion feature of these convertibledebentures amounted to $2,782,697 at year end.** Includes sums owed in respect of an earn-out provision related to our acquisition of FAAC, in the amount of $13.4 million.*** Includes obligations related to special severance pay arrangements in addition to the severance amounts due to certain employees pursuant to Israeli severance pay law.

RISK FACTORS

The following factors, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this Report andpresented elsewhere by management from time to time. Business-Related Risks

We have had a history of losses and may incur future losses.

We were incorporated in 1990 and began our operations in 1991. We have funded our operations principally from funds raised in each of the initial public offering ofour common stock in February 1994; through subsequent public and private offerings of our common stock and equity and debt securities convertible or exercisable into sharesof our common stock; research contracts and supply contracts; funds received under research and development grants from the Government of Israel; and sales of products thatwe and our subsidiaries manufacture. We have incurred significant net losses since our inception. Additionally, as of December 31, 2004, we had an accumulated deficit ofapproximately $119.0 million. There can be no assurance that we will ever be able to achieve or maintain profitability consistently or that our business will continue to exist.

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Our existing indebtedness may adversely affect our ability to obtain additional funds and may increase our vulnerability to economic or business downturns.

Our bank and certificated indebtedness aggregated approximately $5.5 million as of December 31, 2004. Accordingly, we are subject to the risks associated with

indebtedness, including:

· we must dedicate a portion of our cash flows from operations to pay debt service costs and, as a result, we have less funds available for operations, futureacquisitions of consumer receivable portfolios, and other purposes;

· it may be more difficult and expensive to obtain additional funds through financings, if available at all;

· we are more vulnerable to economic downturns and fluctuations in interest rates, less able to withstand competitive pressures and less flexible in reacting to

changes in our industry and general economic conditions; and

· if we default under any of our existing debt instruments or if our creditors demand payment of a portion or all of our indebtedness, we may not havesufficient funds to make such payments.

The occurrence of any of these events could materially adversely affect our results of operations and financial condition and adversely affect our stock price.

The agreements governing the terms of our debentures contain numerous affirmative and negative covenants that limit the discretion of our management with respectto certain business matters and place restrictions on us, including obligations on our part to preserve and maintain our assets and restrictions on our ability to incur or guaranteedebt, to merge with or sell our assets to another company, and to make significant capital expenditures without the consent of the debenture holders. Our ability to comply withthese and other provisions of such agreements may be affected by changes in economic or business conditions or other events beyond our control.

Failure to comply with the terms of our debentures could result in a default that could have material adverse consequences for us.

A failure to comply with the obligations contained in our debenture agreements could result in an event of default under such agreements which could result in anacceleration of the debentures and the acceleration of debt under other instruments evidencing indebtedness that may contain cross-acceleration or cross-default provisions. Ifthe indebtedness under the debentures or other indebtedness were to be accelerated, there can be no assurance that our assets would be sufficient to repay in full suchindebtedness.

We have pledged a substantial portion of our assets to secure our borrowings.

Our debentures are secured by a substantial portion of our assets. If we default under the indebtedness secured by our assets, those assets would be available to thesecured creditors to satisfy our obligations to the secured creditors, which could materially adversely affect our results of operations and financial condition and adversely affectour stock price.

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We need significant amounts of capital to operate and grow our business.

We require substantial funds to market our products and develop and market new products. To the extent that we are unable to fully fund our operations through

profitable sales of our products and services, we may continue to seek additional funding, including through the issuance of equity or debt securities. However, there can be noassurance that we will obtain any such additional financing in a timely manner, on acceptable terms, or at all. If additional funds are raised by issuing equity securities,stockholders may incur further dilution. If additional funding is not secured, we will have to modify, reduce, defer or eliminate parts of our anticipated future commitmentsand/or programs.

We may not be successful in operating new businesses.

Prior to the acquisitions of IES and MDT in 2002 and the acquisitions of FAAC and Epsilor in January 2004 and AoA in August 2004, our primary business was themarketing and sale of products based on primary and refuelable Zinc-Air fuel cell technology and advancements in battery technology for defense and security products andother military applications, electric vehicles and consumer electronics. As a result of our acquisitions, a substantial component of our business is the marketing and sale of hi-tech multimedia and interactive training solutions and sophisticated lightweight materials and advanced engineering processes used to armor vehicles. These are relatively newbusinesses for us and our management group has limited experience operating these types of businesses. Although we have retained our acquired companies’ managementpersonnel, we cannot assure that such personnel will continue to work for us or that we will be successful in managing these new businesses. If we are unable to successfullyoperate these new businesses, our business, financial condition and results of operations could be materially impaired.

Our acquisition strategy involves various risks.

Part of our strategy is to grow through the acquisition of companies that will complement our existing operations or provide us with an entry into markets we do notcurrently serve. Growth through acquisitions involves substantial risks, including the risk of improper valuation of the acquired business and the risk of inadequate integration.There can be no assurance that suitable acquisition candidates will be available, that we will be able to acquire or manage profitably such additional companies or that futureacquisitions will produce returns that justify our investments therein. In addition, we may compete for acquisition and expansion opportunities with companies that havesignificantly greater resources than we do. Furthermore, acquisitions could disrupt our ongoing business, distract the attention of our senior officers, make it difficult to maintainour operational standards, controls and procedures and subject us to contingent and latent risks that are different, in nature and magnitude, than the risks we currently face.

We may finance future acquisitions with cash from operations or additional debt or equity financings. There can be no assurance that we will be able to generateinternal cash or obtain financing from external sources or that, if available, such financing will be on terms acceptable to us. The issuance of additional common stock to financeacquisitions may result in substantial dilution to our stockholders. Any debt financing may significantly increase our leverage and may involve restrictive covenants which limitour operations.

We may not successfully integrate our acquisitions.

In light of our acquisitions of IES, MDT, FAAC, Epsilor and AoA, our success will depend in part on our ability to manage the combined operations of thesecompanies and to integrate the operations and personnel of these companies along with our other subsidiaries and divisions into a single organizational structure. There can beno assurance that we will be able to effectively integrate the operations of our subsidiaries and divisions and our acquired businesses into a single organizational structure.Integration of these operations could also place additional pressures on our management as well as on our key technical resources. The failure to successfully manage thisintegration could have an adverse material effect on us.

If we are successful in acquiring additional businesses, we may experience a period of rapid growth that could place significant additional demands on, and require usto expand, our management, resources and management information systems. Our failure to manage any such rapid growth effectively could have a material adverse effect onour financial condition, results of operations and cash flows.

If we are unable to manage our growth, our operating results will be impaired.

As a result of our acquisitions, we are currently experiencing a period of significant growth and development activity which could place a significant strain on ourpersonnel and resources. Our activity has resulted in increased levels of responsibility for both existing and new management personnel. Many of our management personnelhave had limited or no experience in managing growing companies. We have sought to manage our current and anticipated growth through the recruitment of additionalmanagement and technical personnel and the implementation of internal systems and controls. However, our failure to manage growth effectively could adversely affect ourresults of operations.

A significant portion of our business is dependent on government contracts and reduction or reallocation of defense or law enforcement spending could reduce ourrevenues.

Many of the customers of IES, FAAC and AoA to date have been in the public sector of the U.S., including the federal, state and local governments, and in the publicsectors of a number of other countries, and most of MDT’s customers have been in the public sector in Israel, in particular the Ministry of Defense. Additionally, all of EFB’ssales to date of battery products for the military and defense sectors have been in the public sector in the United States. A significant decrease in the overall level or allocation ofdefense or law enforcement spending in the U.S. or other countries could reduce our revenues and have a material adverse effect on our future results of operations and financialcondition. MDT has already experienced a slowdown in orders from the Ministry of Defense due to budget constraints and a requirement of U.S. aid to Israel that a substantialproportion of such aid be spent in the U.S., where MDT has only recently opened a factory.

Sales to public sector customers are subject to a multiplicity of detailed regulatory requirements and public policies as well as to changes in training and purchasingpriorities. Contracts with public sector customers may be conditioned upon the continuing availability of public funds, which in turn depends upon lengthy and complexbudgetary procedures, and may be subject to certain pricing constraints. Moreover, U.S. government contracts and those of many international government customers maygenerally be terminated for a variety of factors when it is in the best interests of the government and contractors may be suspended or debarred for misconduct at the discretionof the government. There can be no assurance that these factors or others unique to government contracts or the loss or suspension of necessary regulatory licenses will notreduce our revenues and have a material adverse effect on our future results of operations and financial condition.

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Our U.S. government contracts may be terminated at any time and may contain other unfavorable provisions.

The U.S. government typically can terminate or modify any of its contracts with us either for its convenience or if we default by failing to perform under the terms of

the applicable contract. A termination arising out of our default could expose us to liability and have a material adverse effect on our ability to re-compete for future contractsand orders. Our U.S. government contracts contain provisions that allow the U.S. government to unilaterally suspend us from receiving new contracts pending resolution ofalleged violations of procurement laws or regulations, reduce the value of existing contracts, issue modifications to a contract and control and potentially prohibit the export ofour products, services and associated materials.

A negative audit by the U.S. government could adversely affect our business, and we might not be reimbursed by the government for costs that we have expended onour contracts.

Government agencies routinely audit government contracts. These agencies review a contractor's performance on its contract, pricing practices, cost structure andcompliance with applicable laws, regulations and standards. If we are audited, we will not be reimbursed for any costs found to be improperly allocated to a specific contract,while we would be required to refund any improper costs for which we had already been reimbursed. Therefore, an audit could result in a substantial adjustment to ourrevenues. If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination ofcontracts, forfeitures of profits, suspension of payments, fines and suspension or debarment from doing business with United States government agencies. We could sufferserious reputational harm if allegations of impropriety were made against us. A governmental determination of impropriety or illegality, or an allegation of impropriety, couldhave a material adverse effect on our business, financial condition or results of operations.

We may be liable for penalties under a variety of procurement rules and regulations, and changes in government regulations could adversely impact our revenues,operating expenses and profitability.

Our defense and commercial businesses must comply with and are affected by various government regulations that impact our operating costs, profit margins and ourinternal organization and operation of our businesses. Among the most significant regulations are the following:

· the U.S. Federal Acquisition Regulations, which regulate the formation, administration and performance of government contracts;

· the U.S. Truth in Negotiations Act, which requires certification and disclosure of all cost and pricing data in connection with contract negotiations; and

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· the U.S. Cost Accounting Standards, which impose accounting requirements that govern our right to reimbursement under certain cost-based government

contracts.

These regulations affect how we and our customers do business and, in some instances, impose added costs on our businesses. Any changes in applicable laws couldadversely affect the financial performance of the business affected by the changed regulations. With respect to U.S. government contracts, any failure to comply with applicablelaws could result in contract termination, price or fee reductions or suspension or debarment from contracting with the U.S. government.

Our operating margins may decline under our fixed-price contracts if we fail to estimate accurately the time and resources necessary to satisfy our obligations.

Some of our contracts are fixed-price contracts under which we bear the risk of any cost overruns. Our profits are adversely affected if our costs under these contractsexceed the assumptions that we used in bidding for the contract. Often, we are required to fix the price for a contract before we finalize the project specifications, which increasesthe risk that we will mis-price these contracts. The complexity of many of our engagements makes accurately estimating our time and resources more difficult.

If we are unable to retain our contracts with the U.S. government and subcontracts under U.S. government prime contracts in the competitive rebidding process, ourrevenues may suffer.

Upon expiration of a U.S. government contract or subcontract under a U.S. government prime contract, if the government customer requires further services of the typeprovided in the contract, there is frequently a competitive rebidding process. We cannot guarantee that we, or if we are a subcontractor that the prime contractor, will win anyparticular bid, or that we will be able to replace business lost upon expiration or completion of a contract. Further, all U.S. government contracts are subject to protest bycompetitors. The termination of several of our significant contracts or nonrenewal of several of our significant contracts, could result in significant revenue shortfalls.

The loss of, or a significant reduction in, U.S. military business would have a material adverse effect on us.

U.S. military contracts account for a significant portion of our business. The U.S. military funds these contracts in annual increments. These contracts requiresubsequent authorization and appropriation that may not occur or that may be greater than or less than the total amount of the contract. Changes in the U.S. military’s budget,spending allocations and the timing of such spending could adversely affect our ability to receive future contracts. None of our contracts with the U.S. military has a minimumpurchase commitment, and the U.S. military generally has the right to cancel its contracts unilaterally without prior notice. We manufacture for the U.S. aircraft and land vehiclearmor systems, protective equipment for military personnel and other technologies used to protect soldiers in a variety of life-threatening or catastrophic situations, and batteriesfor communications devices. The loss of, or a significant reduction in, U.S. military business for our aircraft and land vehicle armor systems, other protective equipment, orbatteries could have a material adverse effect on our business, financial condition, results of operations and liquidity.

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A reduction of U.S. force levels in Iraq may affect our results of operations.

Since the invasion of Iraq by the U.S. and other forces in March 2003, we have received steadily increasing orders from the U.S. military for armoring of vehicles and

military batteries. These orders are the result, in substantial part, from the particular combat situations encountered by the U.S. military in Iraq. We cannot be certain, therefore,to what degree the U.S. military would continue placing orders for our products if the U.S. military were to reduce its force levels or withdraw completely from Iraq. Asignificant reduction in orders from the U.S. military could have a material adverse effect on our business, financial condition, results of operations and liquidity.

There are limited sources for some of our raw materials, which may significantly curtail our manufacturing operations.

The raw materials that we use in manufacturing our armor products include Kevlar®, a patented product of E.I. du Pont de Nemours Co., Inc. We purchase Kevlar inthe form of woven cloth from various independent weaving companies. In the event Du Pont and/or these independent weaving companies were to cease, for any reason, toproduce or sell Kevlar to us, we might be unable to replace it with a material of like weight and strength, or at all. Thus, if our supply of Kevlar were materially reduced or cutoff or if there were a material increase in the price of Kevlar, our manufacturing operations could be adversely affected and our costs increased, and our business, financialcondition and results of operations could be materially adversely affected.

Some of the components of our products pose potential safety risks which could create potential liability exposure for us.

Some of the components of our products contain elements that are known to pose potential safety risks. In addition to these risks, there can be no assurance thataccidents in our facilities will not occur. Any accident, whether occasioned by the use of all or any part of our products or technology or by our manufacturing operations, couldadversely affect commercial acceptance of our products and could result in significant production delays or claims for damages resulting from injuries. Any of these occurrenceswould materially adversely affect our operations and financial condition. In the event that our products, including the products manufactured by MDT and AoA, fail to performas specified, users of these products may assert claims for substantial amounts. These claims could have a materially adverse effect on our financial condition and results ofoperations. There is no assurance that the amount of the general product liability insurance that we maintain will be sufficient to cover potential claims or that the presentamount of insurance can be maintained at the present level of cost, or at all.

Our fields of business are highly competitive.

The competition to develop defense and security products and electric vehicle battery systems, and to obtain funding for the development of these products, is, and isexpected to remain, intense.

Our defense and security products compete with other manufacturers of specialized training systems, including Firearms Training Systems, Inc., a producer ofinteractive simulation systems designed to provide training in the handling and use of small and supporting arms. In addition, we compete with manufacturers and developers ofarmor for cars and vans, including O’Gara-Hess & Eisenhardt, a division of Armor Holdings, Inc.

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Our battery technology competes with other battery technologies, as well as other Zinc-Air technologies. The competition in this area of our business consists of

development stage companies, major international companies and consortia of such companies, including battery manufacturers, automobile manufacturers, energy productionand transportation companies, consumer goods companies and defense contractors.

Various battery technologies are being considered for use in electric vehicles and defense and safety products by other manufacturers and developers, including thefollowing: lead-acid, nickel-cadmium, nickel-iron, nickel-zinc, nickel-metal hydride, sodium-sulfur, sodium-nickel chloride, zinc-bromine, lithium-ion, lithium-polymer,lithium-iron sulfide, primary lithium, rechargeable alkaline and Zinc-Air.

Many of our competitors have financial, technical, marketing, sales, manufacturing, distribution and other resources significantly greater than ours. If we are unable tocompete successfully in each of our operating areas, especially in the defense and security products area of our business, our business and results o f operations could bematerially adversely affected.

Our business is dependent on proprietary rights that may be difficult to protect and could affect our ability to compete effectively.

Our ability to compete effectively will depend on our ability to maintain the proprietary nature of our technology and manufacturing processes through a combinationof patent and trade secret protection, non-disclosure agreements and licensing arrangements.

Litigation, or participation in administrative proceedings, may be necessary to protect our proprietary rights. This type of litigation can be costly and time consumingand could divert company resources and management attention to defend our rights, and this could harm us even if we were to be successful in the litigation. In the absence ofpatent protection, and despite our reliance upon our proprietary confidential information, our competitors may be able to use innovations similar to those used by us to designand manufacture products directly competitive with our products. In addition, no assurance can be given that others will not obtain patents that we will need to license or designaround. To the extent any of our products are covered by third-party patents, we could need to acquire a license under such patents to develop and market our products.

Despite our efforts to safeguard and maintain our proprietary rights, we may not be successful in doing so. In addition, competition is intense, and there can be noassurance that our competitors will not independently develop or patent technologies that are substantially equivalent or superior to our technology. In the event of patentlitigation, we cannot assure you that a court would determine that we were the first creator of inventions covered by our issued patents or pending patent applications or that wewere the first to file patent applications for those inventions. If existing or future third-party patents containing broad claims were upheld by the courts or if we were found toinfringe third-party patents, we may not be able to obtain the required licenses from the holders of such patents on acceptable terms, if at all. Failure to obtain these licensescould cause delays in the introduction of our products or necessitate costly attempts to design around such patents, or could foreclose the development, manufacture or sale ofour products. We could also incur substantial costs in defending ourselves in patent infringement suits brought by others and in prosecuting patent infringement suits againstinfringers.

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We also rely on trade secrets and proprietary know-how that we seek to protect, in part, through non-disclosure and confidentiality agreements with our customers,

employees, consultants, and entities with which we maintain strategic relationships. We cannot assure you that these agreements will not be breached, that we would haveadequate remedies for any breach or that our trade secrets will not otherwise become known or be independently developed by competitors.

We are dependent on key personnel and our business would suffer if we fail to retain them.

We are highly dependent on the presidents of our IES, FAAC and AoA subsidiaries and the general managers of our MDT and Epsilor subsidiaries, and the loss of theservices of one or more of these persons could adversely affect us. We are especially dependent on the services of our Chairman, President and Chief Executive Officer, RobertS. Ehrlich. The loss of Mr. Ehrlich could have a material adverse effect on us. We are party to an employment agreement with Mr. Ehrlich, which agreement expires at the endof 2005, and we may not be able to renew such contract on terms acceptable to us, or at all. We do not have key-man life insurance on Mr. Ehrlich.

There are risks involved with the international nature of our business.

A significant portion of our sales are made to customers located outside the U.S., primarily in Europe and Asia. In 2004, 2003 and 2002, without taking account ofrevenues derived from discontinued operations, 19%, 42% and 56%, respectively, of our revenues, were derived from sales to customers located outside the U.S. We expect thatour international customers will continue to account for a substantial portion of our revenues in the near future. Sales to international customers may be subject to political andeconomic risks, including political instability, currency controls, exchange rate fluctuations, foreign taxes, longer payment cycles and changes in import/export regulations andtariff rates. In addition, various forms of protectionist trade legislation have been and in the future may be proposed in the U.S. and certain other countries. Any resultingchanges in current tariff structures or other trade and monetary policies could adversely affect our sales to international customers.

Investors should not purchase our common stock with the expectation of receiving cash dividends.

We currently intend to retain any future earnings for funding growth and, as a result, do not expect to pay any cash dividends in the foreseeable future. Market-Related Risks

The price of our common stock is volatile.

The market price of our common stock has been volatile in the past and may change rapidly in the future. The following factors, among others, may cause significantvolatility in our stock price:

· Announcements by us, our competitors or our customers;

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· The introduction of new or enhanced products and services by us or our competitors;

· Changes in the perceived ability to commercialize our technology compared to that of our competitors;

· Rumors relating to our competitors or us;

· Actual or anticipated fluctuations in our operating results;

· The issuance of our securities, including warrants, in connection with financings and acquisitions; and

· General market or economic conditions.

If our shares were to be delisted, our stock price might decline further and we might be unable to raise additional capital.

One of the continued listing standards for our stock on the Nasdaq National Market is the maintenance of a $1.00 bid price. Our stock price has traded below $1.00 in

the past. If our bid price were to go and remain below $1.00 for 30 consecutive business days, Nasdaq could notify us of our failure to meet the continued listing standards, afterwhich we would have 180 calendar days to correct such failure or be delisted from the Nasdaq National Market.

Although we would have the opportunity to appeal any potential delisting, there can be no assurances that this appeal would be resolved favorably. As a result, therecan be no assurance that our common stock will remain listed on the Nasdaq National Market. If our common stock were to be delisted from the Nasdaq National Market, wemight apply to be listed on the Nasdaq SmallCap market; however, there can be no assurance that we would be approved for listing on the Nasdaq SmallCap market, which hasthe same $1.00 minimum bid and other similar requirements as the Nasdaq National Market. If we were to move to the Nasdaq SmallCap market, current Nasdaq regulationswould give us the opportunity to obtain an additional 180-day grace period and an additional 90-day grace period after that if we meet certain net income, stockholders’ equityor market capitalization criteria. While our stock would continue to trade on the over-the-counter bulletin board following any delisting from the Nasdaq, any such delisting ofour common stock could have an adverse effect on the market price of, and the efficiency of the trading market for, our common stock. Also, if in the future we were todetermine that we need to seek additional equity capital, it could have an adverse effect on our ability to raise capital in the public equity markets.

In addition, if we fail to maintain Nasdaq listing for our securities, and no other exclusion from the definition of a “penny stock” under the Securities Exchange Act of1934, as amended, is available, then any broker engaging in a transaction in our securities would be required to provide any customer with a risk disclosure document,disclosure of market quotations, if any, disclosure of the compensation of the broker-dealer and its salesperson in the transaction and monthly account statements showing themarket values of our securities held in the customer’s account. The bid and offer quotation and compensation information must be provided prior to effecting the transaction andmust be contained on the customer’s confirmation. If brokers become subject to the “penny stock” rules when engaging in transactions in our securities, they would become lesswilling to engage in transactions, thereby making it more difficult for our stockholders to dispose of their shares.

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We expect our auditors to report a material weakness in our internal controls. I f we fail to achieve and maintain effective internal controls in accordance with

Section 404 of the Sarbanes-Oxley Act, we may not be able to accurately report our financial results.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with this Annual Report on Form 10-K for the fiscal year ending December 31, 2004, we arerequired to furnish a report by our management on our internal control over financial reporting.

Pursuant to Securities and Exchange Commission Release No. 34-50754, which, subject to certain conditions, provides up to 45 additional days beyond the due date ofthis Form 10-K for the filing of management’s annual report on internal control over financial reporting required by Item 308(a) of Regulation S-K, and the related attestationreport of the independent registered public accounting firm, as required by Item 308(b) of Regulation S-K, management’s report on internal control over financial reporting andthe associated report on the audit of management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, are notfiled herein and are expected to be filed no later than May 2, 2005.

The internal control report must contain (i) a statement of management’s responsibility for establishing and maintaining adequate internal control over financialreporting, (ii) a statement identifying the framework used by management to conduct the required evaluation of the effectiveness of our internal control over financial reporting,(iii) management’s assessment of the effectiveness of our internal control over financial reporting as of the end of our most recent fiscal year, including a statement as towhether or not internal control over financial reporting is effective, and (iv) a statement that our independent registered public accounting firm has issued an attestation reporton management’s assessment of internal control over financial reporting.

We expect that our auditors will inform us, although they have not yet done so, that they identified significant deficiencies that constitute a material weakness understandards established by the American Institute of Certified Public Accountants (AICPA). A material weakness is a condition in which the design or operation of one or more ofthe internal control components does not reduce to a relatively low level the risk that misstatements caused by error or fraud in amounts that would be material in relation to thefinancial statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions. We expectthat our auditors will report to us that at December 31, 2004, we had a significant deficiency in our financial statement closing process and related processes because the size ouraccounting and finance department and the press of work related to our recent acquisitions caused us to be unable independently to comply with the selection and application ofgenerally accepted accounting principles related to highly complex financial transactions applicable to equity issuances and business combinations.

A s a public company, we will have significant requirements for enhanced financial reporting and internal controls. The process of designing and implementingeffective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments and to expendsignificant resources to maintain a system of internal controls that is adequate to satisfy our reporting obligations as a public company. We cannot assure you that the measureswe have taken or will take to remediate any material weaknesses or that we will implement and maintain adequate controls over our financial processes and reporting in thefuture as we continue our rapid growth.

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If we are unable to establish appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations, result in

material mis-statements in our financial statements, harm our operating results, cause investors to lose confidence in our reported financial information and have a negativeeffect on the market price for shares of our common stock.

A substantial number of our shares are available for sale in the public market and sales of those shares could adversely affect our stock price.

Sales of a substantial number of shares of common stock into the public market, or the perception that those sales could occur, could adversely affect our stock price orcould impair our ability to obtain capital through an offering of equity securities. As of February 28, 2005, we had 80,103,668 shares of common stock issued and outstanding.Of these shares, most are freely transferable without restriction under the Securities Act of 1933, and a substantial portion of the remaining shares may be sold subject to thevolume restrictions, manner-of-sale provisions and other conditions of Rule 144 under the Securities Act of 1933.

Exercise of our warrants, options and convertible debt could adversely affect our stock price and will be dilutive.

As of February 28, 2005, there were outstanding warrants to purchase a total of 16,961,463 shares of our common stock at a weighted average exercise price of $1.55per share, options to purchase a total of 9,102,761 shares of our common stock at a weighted average exercise price of $1.28 per share, of which 7,002,390 were vested, at aweighted average exercise price of $1.28 per share, and outstanding debentures convertible into a total of 3,156,298 shares of our common stock at a weighted averageconversion price of $1.44 per share. Holders of our options, warrants and convertible debt will probably exercise or convert them only at a time when the price of our commonstock is higher than their respective exercise or conversion prices. Accordingly, we may be required to issue shares of our common stock at a price substantially lower than themarket price of our stock. This could adversely affect our stock price. In addition, if and when these shares are issued, the percentage of our common stock that existingstockholders own will be diluted.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could discourage a takeover.

Provisions of our amended and restated certificate of incorporation may have the effect of making it more difficult for a third party to acquire, or of discouraging athird party from attempting to acquire, control of us. These provisions could limit the price that certain investors might be willing to pay in the future for shares of our commonstock. These provisions:

· divide our board of directors into three classes serving staggered three-year terms;

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· only permit removal of directors by stockholders “for cause,” and require the affirmative vote of at least 85% of the outstanding common stock to so

remove; and

· allow us to issue preferred stock without any vote or further action by the stockholders.

The classification system of electing directors and the removal provision may tend to discourage a third-party from making a tender offer or otherwise attempting toobtain control of us and may maintain the incumbency of our board of directors, as the classification of the board of directors increases the difficulty of replacing a majority ofthe directors. These provisions may have the effect of deferring hostile takeovers, delaying changes in our control o r management, or may make it more difficult forstockholders to take certain corporate actions. The amendment of any of these provisions would require approval by holders of at least 85% of the outstanding common stock. Israel-Related Risks

A significant portion of our operations takes place in Israel, and we could be adversely affected by the economic, political and military conditions in that region.

The offices and facilities of three of our subsidiaries, EFL, MDT and Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona, respectively, all of which arewithin Israel’s pre-1967 borders). Most of our senior management is located at EFL’s facilities. Although we expect that most of our sales will be made to customers outsideIsrael, we are nonetheless directly affected by economic, political and military conditions in that country. Accordingly, any major hostilities involving Israel or the interruptionor curtailment of trade between Israel and its present trading partners could have a material adverse effect on our operations. Since the establishment of the State of Israel in1948, a number of armed conflicts have taken place between Israel and its Arab neighbors and a state of hostility, varying in degree and intensity, has led to security andeconomic problems for Israel.

Historically, Arab states have boycotted any direct trade with Israel and to varying degrees have imposed a secondary boycott on any company carrying on trade withor doing business in Israel. Although in October 1994, the states comprising the Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Kuwait, Dubai, Bahrainand Oman) announced that they would no longer adhere to the secondary boycott against Israel, and Israel has entered into certain agreements with Egypt, Jordan, the PalestineLiberation Organization and the Palestinian Authority, Israel has not entered into any peace arrangement with Syria or Lebanon. Moreover, since September 2000, there hasbeen a significant deterioration in Israel’s relationship with the Palestinian Authority, and a significant increase in terror and violence. Efforts to resolve the problem have failedto result in an agreeable solution. Continued hostilities between the Palestinian community and Israel and any failure to settle the conflict may have a material adverse effect onour business and us. Moreover, the current political and security situation in the region has already had an adverse effect on the economy of Israel, which in turn may have anadverse effect on us.

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Service of process and enforcement of civil liabilities on us and our officers may be difficult to obtain.

We are organized under the laws of the State of Delaware and will be subject to service of process in the United States. However, approximately 22% of our assets arelocated outside the United States. In addition, two of our directors and most of our executive officers are residents of Israel and a portion of the assets of such directors andexecutive officers are located outside the United States.

There is doubt as to the enforceability of civil liabilities under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, in originalactions instituted in Israel. As a result, it may not be possible for investors to enforce or effect service of process upon these directors and executive officers or to judgments ofU.S. courts predicated upon the civil liability provisions of U.S. laws against our assets, as well as the assets of these directors and executive officers. In addition, awards ofpunitive damages in actions brought in the U.S. or elsewhere may be unenforceable in Israel.

Exchange rate fluctuations between the U.S. dollar and the Israeli NIS may negatively affect our earnings.

Although a substantial majority of our revenues and a substantial portion of our expenses are denominated in U.S. dollars, a portion of our costs, including personneland facilities-related expenses, is incurred in New Israeli Shekels (NIS). Inflation in Israel will have the effect of increasing the dollar cost of our operations in Israel, unless it isoffset on a timely basis by a devaluation of the NIS relative to the dollar. In 2004, the inflation adjusted NIS appreciated against the dollar, which raised the dollar cost of ourIsraeli operations.

Some of our agreements are governed by Israeli law.

Israeli law governs some of our agreements, such as our lease agreements on our subsidiaries’ premises in Israel, and the agreements pursuant to which we purchasedIES, MDT and Epsilor. While Israeli law differs in certain respects from American law, we do not believe that these differences materially adversely affect our rights orremedies under these agreements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements Page

Consolidated Financial Statements Reports of Independent Registered Public Accounting Firms F-2Consolidated Balance Sheets F-4Consolidated Statements of Operations F-6Statements of Changes in Shareholders’ Equity F-7Consolidated Statements of Cash Flows F-10Notes to Consolidated Financial Statements F-14

Supplementary Financial Data Quarterly Financial Data (unaudited) for the two years ended December 31, 2004 F-61

Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts F-62

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ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures

As of December 31, 2004, our management, including the principal executive officer and principal financial officer, evaluated our disclosure controls and proceduresrelated to the recording, processing, summarization, and reporting of information in our periodic reports that we file with the SEC. These disclosure controls and procedures areintended to ensure that material information relating to us, including our subsidiaries, is made known to our management, including these officers, by other of our employees,and that this information is recorded, processed, summarized, evaluated, and reported, as applicable, within the time periods specified in the SEC’s rules and forms. Due to theinherent limitations of control systems, not all misstatements may be detected. These inherent limitations include the realities that judgments in decision-making can be faultyand that breakdowns can occur because of simple error or mistake. Any system of controls and procedures, no matter how well designed and operated, can at best provide onlyreasonable assurance that the objective of the system are met and management necessarily is required to apply its judgment in evaluating the cost benefit relationship of possiblecontrols and procedures. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override ofthe control. Our controls and procedures are intended to provide only reasonable, not absolute, assurance that the above objectives have been met.

Based on their evaluation as of December 31, 2004, and solely because of the material weaknesses described below, our principal executive officer and principalfinancial officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) were noteffective to ensure that the information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in SEC rules and forms.

I n light of the material weakness described below, our management performed additional analyses and other post-closing procedures to ensure our consolidatedfinancial statements are prepared in accordance with generally accepted accounting principles in the United States (U.S. GAAP). Accordingly, management believes that theconsolidated financial statements included in this report fairly present in all material respects our financial position, results of operations and cash flows for the periodspresented. Management’s Report on Internal Control Over Financial Reporting

Our management, including our principal executive and financial officers, is responsible for establishing and maintaining adequate internal control over our financialreporting. Our management has evaluated the effectiveness of our internal controls, pursuant to the requirements of Sarbanes-Oxley Section 404, as of the end of the periodcovered by this Annual Report on Form 10-K for December 31, 2004. In making our assessment of internal control over financial reporting, management used the criteria setforth by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission in Internal Control - Integrated Framework. In accordance with the rules of theSEC, we did not assess the internal control over financial reporting of Armour of America, Incorporated, which we acquired in August 2004, financial statements of whichreflect total assets of 4% of our consolidated assets as of December 31, 2004, and total revenues of 5% of our consolidated revenues for the year then ended. In our AnnualReport on Form 10-K for the year ending December 31, 2005, we will be required to provide an assessment of our compliance that takes into account an assessment of Armourof America, Incorporated and all of our other currently existing subsidiaries as of December 31, 2005.

- 35 -

For the reasons described below, we have concluded that there were material weaknesses in our internal controls at December 31, 2004. We note in this connection

that our Independent Registered Public Accounting Firm audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), ourconsolidated financial statements and financial statement schedule as of and for the year ended December 31, 2004, and their report dated March 24, 2005 expressed anunqualified opinion with respect thereto.

On November 22, 2004, the Audit Committee of our Board of Directors, on the recommendation of our management and after discussion with our IndependentRegistered Public Accounting Firm, made an internal determination and concluded that our Annual Report on Form 10-K for the year ended December 31, 2003, including thefinancial statements that our Independent Registered Public Accounting Firm had previously audited that are contained therein, contained certain errors related to the re-pricingof warrants and grant of additional warrants to certain of our investors and others and the amortization of debt discount arising from the allocation of the debt discount betweenthe convertible debentures and their detachable warrants. The net effect of these errors, which generally related to the timing and characterization of certain non-cash expenses,was (i) to increase our net loss attributable to common stockholders for 2003 by approximately $579,000 and to decrease our net loss for the first half of 2004 by approximately$608,000, and (ii) to decrease our net loss attributable to common stockholders for the nine and three months ended September 30, 2004 by approximately $1,583,778 and$976,129, respectively. The Audit Committee of our Board of Directors therefore concluded to restate certain previously issued financial statements contained in our AnnualReport on Form 10-K for the year ended December 31, 2003. The decision to restate these financial statements was made by our Audit Committee, upon the recommendation ofour management and with the concurrence of our Independent Registered Public Accounting Firm.

As a result of the restatement referred to in the preceding paragraph, we have identified material weaknesses for inadequate controls related to the financial statementclose process, convertible debentures and share capital processes as it applies to non-routine and highly complex financial transactions. A material weakness is a controldeficiency (within the meaning of the Public Company Accounting Oversight Board (“PCAOB”) Auditing Standard No. 2), or combination of control deficiencies, that resultsin more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The material weaknesses arise frominsufficient staff with technical accounting expertise to independently apply our accounting policies, as they relate to non-routine and highly complex transactions, in accordancewith U.S. generally accepted accounting principles. Management has identified that due to the reasons described above, we did not consistently follow established internalcontrol over financial reporting procedures related to the analysis, documentation and review of selection of the appropriate accounting treatment for non-routine and highlycomplex transactions. Because of these material weaknesses, we have concluded that we did not maintain effective internal control over financial reporting as of December 31,2004, based on the criteria in Internal Control-Integrated Framework.

- 36 -

The foregoing management assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004, has been audited by Kost, Forer,

Gabbay and Kassierer, a member of Ernst & Young Global, the registered public accounting firm that audited the financial statements included in our annual report, as stated intheir report which is included below. Management’s Response to the Material Weaknesses

In response to the material weaknesses described above, we have undertaken to take the following initiatives with respect to our internal controls and procedures thatwe believe are reasonably likely to improve and materially affect our internal control over financial reporting. We anticipate that remediation will be continuing throughoutfiscal 2005, during which we expect to continue pursuing appropriate corrective actions, including the following:

Ø Preparing appropriate written documentation of our financial control procedures;

Ø Adding additional qualified staff to our finance department;

Ø Scheduling training for accounting staff to heighten awareness of generally accepted accounting principles applicable to complex transactions;

Ø Strengthening our internal review procedures in conjunction with our ongoing work to enhance our internal controls so as to enable us to identify andadjust items proactively;

Ø Engaging an outside accounting firm to support our Sarbanes-Oxley Section 404 compliance activities and to provide technical expertise in the selection

and application of generally accepted accounting principles related to complex transactions to identify areas that require control or process improvementsand to consult with us on the appropriate accounting treatment applicable to complex transactions; and

Ø Implementing the recommendations of our outside accounting consultants.

Our management and Audit Committee will monitor closely the implementation of our remediation plan. The effectiveness of the steps we intend to implement is

subject to continued management review, as well as Audit Committee oversight, and we may make additional changes to our internal control over financial reporting.

We cannot assure you that we will not in the future identify further material weaknesses in our internal control over financial reporting. We currently are unable todetermine when the above-mentioned material weaknesses will be fully remediated. However, because remediation will not be completed until we have added finance staff andstrengthened pertinent controls, we presently anticipate that we will report in our Quarterly Report on Form 10-Q for the second quarter of fiscal 2005 that material weaknessescontinue to exist.

- 37 -

Changes in Internal Controls Over Financial Reporting

Except as noted above, there have been no changes in our internal control over financial reporting that occurred during our last fiscal quarter to which this AnnualReport on Form 10-K relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

- 38 -

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a)The following documents are filed as part of this amended report:

(1) Financial Statements - See Index to Financial Statements on page above.

(2) Financial Statements Schedules - Schedule II - Valuation and Qualifying Accounts. All schedules other than those listed above are omitted because of theabsence of conditions under which they are required or because the required information is presented in the financial statements or related notes thereto.

(3) Exhibits - The following Exhibits are either filed herewith or have previously been filed with the Securities and Exchange Commission and are referred to and

incorporated herein by reference to such filings:

Exhibit No. Description*23.1 Consent of Kost, Forer, Gabbay & Kassierer, a member of Ernst & Young Global*23.2 Consent of Stark Winter Schenkein & Co., LLP*31.1 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*31.2 Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*32.1 Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*32.2 Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

* Filed herewith

- 39 -

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amended report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on August 15 , 2005. AROTECH CORPORATION

By: /s/ Robert S. Ehrlich

Name: Robert S. Ehrlich Title:

Chairman, President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this amended report has been signed below by the following persons on behalf of the registrantand in the capacities and on the dates indicated.

Signature Title Date

/s/ Robert S. Ehrlich

Robert S. Ehrlich

Chairman, President, Chief Executive Officer and Director(Principal Executive Officer) August 15 , 2005

/s/ Avihai Shen

Avihai Shen

Vice President - Finance(Principal Financial Officer) August 15 , 2005

/s/ Danny Waldner

Danny Waldner

Controller(Principal Accounting Officer) August 15 , 2005

/s/ Steven Esses

Steven Esses

Executive Vice President, Chief Operating Officer and Director August 15 , 2005

/s/ Jay M. Eastman

Dr. Jay M. Eastman

Director August 15 , 2005

/s/ Lawrence M. Miller

Lawrence M. Miller


Jack E. Rosenfeld Director August , 2005

/s/ Seymour Jones

Seymour Jones


Edward J. Borey

Director August , 2005

- 40 -

AROTECH CORPORATION AND ITS SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2004

IN U.S. DOLLARS

INDEX

Page

Reports of Independent Registered Public Accounting Firms

2 - 3

Consolidated Balance Sheets

4 - 5

Consolidated Statements of Operations

6

Statements of Changes in Stockholders’ Equity

7 - 9

Consolidated Statements of Cash Flows

10 - 13

Notes to Consolidated Financial Statements

14 - 60

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders of

AROTECH CORPORATION

We have audited the accompanying consolidated balance sheets of Arotech Corporation (the “Company”) and its subsidiaries as of December 31, 2004 and 2003, and therelated consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004. Our audits alsoincluded the financial statement schedule listed in Item 15(a)(2) of the Company’s 10-K. These financial statements and schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We did not audit the financial statements of “Armor ofAmerica,” a wholly-owned subsidiary of the Company, financial statements of which reflect total assets of 4% of the consolidated assets of the Company as of December 31,2004, and total revenues of 5% of the consolidated revenues of the Company for the year then ended. Those statements were audited by other auditors whose report has beenfurnished to us, and our opinion, insofar as it relates to the data included for this subsidiary, is based solely on the report of the other auditors.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion based on our audits and the other auditors the consolidated financial statements referred to above present fairly, in all material respects, the consolidatedfinancial position of the Company and its subsidiaries as of December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of thethree years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Additionally, in our opinion the related financialstatement schedule, when considered in relation to the basic financial statements and schedule taken as a whole, present fairly in all material respects the information set forththerein.

As discussed in Note 1.b., the Consolidated Financial Statements at December 31, 2003 and for the year then ended have been restated for the matters set forth therein. Tel Aviv, Israel KOST, FORER, GABBAY & KASIERERMarch 24, 2005 A Member of Ernst & Young Global

F-2

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders of

AROTECH CORPORATION We have audited management’s assessment, included in the accompanying “Report of Management on Internal Control Over Financial Reporting,” that Arotech Corporationdid not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of material weaknesses in internal controls related to thefinancial statement close process, the convertible debentures and share capital processes as it applies to non-routine and highly complex financial transactions, based on criteriaestablished in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). ArotechCorporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control overfinancial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financialreporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and performthe audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control,and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of thecompany; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company;and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a materialeffect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or proceduresmay deteriorate.

F-3

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual orinterim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment. Managementidentified material weaknesses for inadequate controls related to the financial statement close process, convertible debentures and share capital processes as it applies to non-routine and highly complex financial transactions. The material weaknesses arise from insufficient staff with technical accounting expertise to independently apply theCompany’s accounting policies, as they relate to non-routine and highly complex transactions, in accordance with U.S. generally accepted accounting principles (“GAAP”).Management has identified that due to the reasons described above, the Company did not consistently follow established internal control over financial reporting proceduresrelated to the analysis, documentation and review of selection of the appropriate accounting treatment for non-routine and highly complex transactions. These materialweaknesses resulted in a restatement of the 2003 consolidated financial statements and quarterly unaudited consolidated financial statements for each of the quarters throughSeptember 30, 2004 and related to the errors in the appropriate accounting treatment to be applied to (i) re-pricing of warrants and grant of additional warrants to certaininvestors and others, and (ii) amortization of debt discount arising from the allocation of the debt discount between the convertible debentures and their detachable warrants.The net effect of these errors, which generally related to the timing and characterization of certain non-cash expenses, was (i) to increase net loss attributable to commonstockholders for 2003 by approximately $579,000 and to decrease net loss for the first half of 2004 by approximately $608,000, and (ii) to decrease net loss attributable tocommon stockholders for the nine and three months ended September 30, 2004 by approximately $1,583,778 and $976,129, respectively. The above material weaknessesresulted in the material misstatement of amount of convertible debentures, finance expenses related to convertible debentures and stockholders’ equity. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the December 31, 2004 consolidated financialstatements, and this report does not affect our report dated March 24, 2005 on those consolidated financial statements. As indicated in the accompanying “Report of Management on Internal Control Over Financial Reporting,” management’s assessment of and conclusion on the effectiveness ofinternal control over financial reporting did not include the internal controls of Armour of America Inc., a wholly-owned subsidiary whose total assets and total revenuesrepresent 4% and 5%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2004, which was acquired by theCompany in a purchase business combination during 2004. Our audit of internal control over financial reporting of Arotech Corporation also did not include an evaluation of theinternal control over financial reporting of Armour of America Inc. In our opinion, management’s assessment that Arotech Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated,in all material respects, based on the COSO control criteria. Also, in our opinion, because of the effect of the material weakness described above on the achievement of theobjectives of the control criteria, Arotech Corporation has not maintained effective internal control over financial reporting as of December 31, 2004, based on the COSOcontrol criteria. Tel-Aviv, Israel KOST, FORER, GABBAY & KASIERERApril 21, 2005 A Member of Ernst & Young Global

F-4

Stark ♦ Winter ♦ Schenkein

Report of Independent Registered Public Accounting Firm To the ShareholderArmour of America, Inc.Gardena, California We have audited the accompanying balance sheets of Armour of America, Inc. as of December 31, 2004, and the related statements of income, stockholder’s equity and cashflows for the period August 11, 2004 to December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Armour of America, Inc. as of December 31, 2004, andthe results of its operations, stockholder’s equity and cash flows for the period August 11, 2004 to December 31, 2004, in conformity with accounting principles generallyaccepted in the United States of America. /s/ Stark Winter Schenkein & Co., LLP Denver, ColoradoJanuary 31, 2005

Stark ♦ Winter ♦ Schenkein & Co., LLP ♦ Certified Public Accountants ♦ Financial Consultants

7535 East Hampden Avenue ♦ Suite 109 ♦ Denver, Colorado 80231Phone: 303.694.6700 ♦ Fax: 303.694.6761 ♦ Toll Free: 888.766.3985 ♦ www.swscpas.com

F-5

AROTECH CORPORATION AND ITS SUBSIDIARIESCONSOLIDATED BALANCE SHEETS

In U.S. dollars December 31, 2004 2003*

ASSETS CURRENT ASSETS:

Cash and cash equivalents $ 6,734,512 $ 13,685,125 Restricted collateral deposits and restricted held-to-maturity securities 6,962,110 706,180 Available for sale marketable securities 135,568 - Trade receivables (net of allowance for doubtful accounts in the amounts of $55,394 and $61,282 as of December 31,

2004 and 2003, respectively) 8,266,880 4,706,423

Unbilled receivables 2,881,468 - Other accounts receivable and prepaid expenses 1,339,393 1,187,371 Inventories 7,277,301 1,914,748 Assets of discontinued operations - 66,068

Total current assets 33,597,232 22,265,915 SEVERANCE PAY FUND 1,980,047 1,023,342 RESTRICTED DEPOSITS 4,000,000 - PROPERTY AND EQUIPMENT, NET 4,600,691 2,292,741 OTHER INTANGIBLE ASSETS, NET 14,368,701 2,375,195 GOODWILL 39,745,516 5,064,555 $ 98,292,187 $ 33,021,748

The accompanying notes are an integral part of the consolidated financial statements.F-6

AROTECH CORPORATION AND ITS SUBSIDIARIESCONSOLIDATED BALANCE SHEETS

In U.S. dollars

December 31, 2004 2003*

LIABILITIES AND STOCKHOLDERS’ EQUITY CURRENT LIABILITIES:

Trade payables $ 6,177,546 $ 1,967,448 Other accounts payable and accrued expenses 5,818,188 4,030,411 ** Current portion of promissory notes due to purchase of subsidiaries 13,585,325 150,000 Short term bank credit and current portion of long term loans 181,352 40,849 Deferred revenues 618,229 140,936 ** Liabilities of discontinued operations - 380,108

Total current liabilities 26,380,640 6,709,752 LONG TERM LIABILITIES

Accrued severance pay 3,422,951 2,814,492 Convertible debenture 1,754,803 1,450,194 Deferred revenues 163,781 220,143 Long term loan 20,891 - Long-term portion of promissory note due to purchase of subsidiaries 980,296 150,000

Total long-term liabilities 6,342,722 4,634,829 COMMITMENTS AND CONTINGENT LIABILITIES (Note 12) MINORITY INTEREST 95,842 51,290 STOCKHOLDERS’ EQUITY:

Share capital - Common stock - $0.01 par value each;

Authorized: 250,000,000 shares and 100,000,000 shares as of December 31, 2004 and 2003, respectively;Issued: 80,576,902 shares and 47,972,407 shares as of December 31, 2004 and 2003, respectively;Outstanding - 80,021,569 shares and 47,417,074 shares as of December 31, 2004 and 2003, respectively

805,769 479,726 Preferred shares - $0.01 par value each;

Authorized: 1,000,000 shares as of December 31, 2004 and 2003; No shares issued and outstanding as ofDecember 31, 2004 and 2003 - -

Additional paid-in capital 189,266,704 135,702,413 Accumulated deficit (118,953,553) (109,911,240)Deferred stock compensation (1,258,295) (8,464)Treasury stock, at cost (common stock - 555,333 shares as of December 31, 2004 and 2003) (3,537,106) (3,537,106)Notes receivable from stockholders (1,222,871) (1,203,881)Accumulated other comprehensive income 372,335 104,429

Total stockholders’ equity 65,472,983 21,625,877 $ 98,292,187 $ 33,021,748

* Restated (see Note 1.b.).** Reclassified.


AROTECH CORPORATION AND ITS SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS

In U.S. dollars

Year ended December 31, 2004 2003* 2002 Revenues $ 49,953,846 $ 17,326,641 $ 6,406,739 Cost of revenues 34,011,094 11,087,840 4,421,748 Gross profit 15,942,752 6,238,801 1,984,991 Operating expenses:

Research and development, net 1,731,379 1,053,408 685,919 Selling and marketing expenses 4,922,217 3,532,636 1,309,669 General and administrative expenses 10,656,866 5,857,876 4,023,103

Amortization of intangible assets and impairment losses 2,814,835 864,910 623,543 In-process research and development write-off - - 26,000

Total operating costs and expenses 20,125,297 11,308,830 6,668,234 Operating loss (4,182,545) (5,070,029) (4,683,243)Financial income (expenses), net (4,228,965) (4,038,709) 100,451 Loss before minorities interests in loss (earnings) of a subsidiaries and tax expenses (8,411,510) (9,108,738) (4,582,792)Income taxes (586,109) (396,193) - Minorities interests in loss (earnings) of a subsidiaries (44,694) 156,900 (355,360)Loss from continuing operations (9,042,313) (9,348,031) (4,938,152) Income (loss) from discontinued operations (including loss on disposal of $4,446,684 during 2002) - 110,410 (13,566,206)Net loss $ (9,042,313) $ (9,237,621) $ (18,504,358)

Deemed dividend to certain stockholders $ (3,328,952) $ (350,000) $ -

Net loss attributable to common stockholders $ (12,371,265) $ (9,587,621) $ (18,504,358)

Basic and diluted net loss per share from continuing operations $ (0.13) $ (0.24) $ (0.15)

Basic and diluted net loss per share from discontinued operations $ 0.00 $ 0.00 $ (0.42)Basic and diluted net loss per share $ (0.18) $ (0.25) $ (0.57)

Weighted average number of shares used in computing basic and diluted net loss per share 69,933,057 38,890,174 32,381,502

* Restated (see Note 1.b.).

The accompanying notes are an integral part of the consolidated financial statements.

F-8

AROTECH CORPORATION AND ITS SUBSIDIARIESSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

In U.S. dollars

Common stock

Shares Amount Additional

paid-incapital Accumulated

deficit Deferred

stockcompensation Treasury

stock

Notesreceivable

fromstockholders

Accumulatedother

comprehensiveloss

Totalcomprehensive

loss Total

stockholders’equity

Balance as of January 1,2002 29,059,469 $ 290,596 $ 105,686,909 $ (82,169,261) $ (18,000) $ (3,537,106) $ (845,081) $ - $ 19,408,057

Adjustment of notes fromstockholders (178,579) (178,579)

Repayment of notes fromemployees 43,308 43,308

Issuance of shares toinvestors 2,041,176 20,412 3,209,588 3,230,000

Issuance of shares toservice providers 368,468 3,685 539,068 542,753

Issuance of shares tolender in respect ofprepaid interestexpenses

387,301 3,873 232,377 236,250

Exercise of options byemployees 191,542 1,915 184,435 (36,500) 149,850

Amortization of deferredstock com-pensation 6,000 6,000

Stock compensation re-lated to options issuedto employees

13,000 130 12,870 13,000 Issuance of shares in

respect of acquisition 3,640,638 36,406 4,056,600 4,093,006 Accrued interest on notes

re-ceivable 160,737 (160,737) - Other comprehensive

loss Foreign currencytranslation adjustment

(1,786) $ (1,786) (1,786)Net loss (18,504,358) (18,504,358) (18,504,358)Total comprehensive loss $ (18,506,144)

Balance as of December

31, 2002 35,701,594 $ 357,017 $ 114,082,584 $ (100,673,619) $ (12,000) $ (3,537,106) $ (1,177,589) $ (1,786) $ 9,037,501


AROTECH CORPORATION AND ITS SUBSIDIARIESSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Common stock



deficit Deferred


stock

Notesreceivable

fromstockholders

Accumulatedother

comprehensiveloss

Totalcomprehensive

loss Total


Balance as of January 1,2003* 35,701,594 $ 357,017 $ 114,082,584 $ (100,673,619) $ (12,000) $ (3,537,106) $ (1,177,589) $ (1,786) $ 9,037,501

Compensation related towarrants issued to theholders of convertibledebentures

5,157,500 5,157,500

Compensation related tobeneficial conversionfeature of convertibledebentures

5,695,543 5,695,543

Issuance of shares onconversion ofconvertible debentures

6,969,605 69,696 6,064,981 (9,677) 6,125,000 Issuance of shares on

exercise of warrants 3,682,997 36,831 3,259,422 3,296,253 Issuance of shares to

consultants 223,600 2,236 159,711 161,947 Compensation related to

grant and reprcing ofwarrants and optionsissued to consultants

229,259 229,259

Compensation related tonon-recourse loangranted to shareholder

38,500 38,500 Deferred stock

compensation 4,750 (4,750) - Amortization of deferred

stock compensation 8,286 8,286 Exercise of options by

employees 689,640 6,896 426,668 433,564 Exercise of options by

consultants 15,000 150 7,200 7,350 Conversion of convertible

promissory note 563,971 5,640 438,720 444,360 Increase in investment in

subsidiary againstcommon stockissuance

126,000 1,260 120,960 122,220

Accrued interest on notesreceivable fromstockholders

16,615 (16,615) - Other comprehensive

income - foreigncurrency translationadjustment

106,215 $ 106,215 106,215

Net loss (9,237,621) (9,237,621) (9,237,621)

$ (9,131,406) Balance as of December

31, 2003 47,972,407 $ 479,726 $ 135,702,413 $ (109,911,240) $ (8,464) $ (3,537,106) $ (1,203,881) $ 104,429 $ 21,625,877



F-10

AROTECH CORPORATION AND ITS SUBSIDIARIESSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYIn U.S. dollars

Common stock



deficit Deferred


stock

Notesreceivable

fromstockholders

Accumulatedother

comprehensiveloss

Totalcomprehensive

loss Total


Balance as of January 1,2004 47,972,407 $ 479,726 $ 135,702,413 $ (109,911,240) $ (8,464) $ (3,537,106) $ (1,203,881) $ 104,429 $ 21,625,877 Issuance of shares, net 14,138,491 141,384 24,252,939 24,394,323 Issuance of shares and

warrants due tosettlement of litigation

450,000 4,500 1,244,328 1,248,828 Issuance of shares to

employees 40,000 400 92,800 93,200 Conversion of convertible

debentures 3,843,728 38,437 3,754,279 3,792,716 Exercise of warrants by

investors and others 11,363,342 113,633 19,119,638 19,233,271 Issuance of shares to

consultants 90,215 902 198,489 199,391 Reclassification to

liability in connectionwith warrants granted

(10,841,020) (10,841,020)Reclassification of

liability to equityrelated to the fair valueof warrants

10,514,181 10,514,181

Compensation related tonon-recourse loangranted to shareholder

(10,000) (10,000)Deferred stock

compensation relatedto options andrestricted stock

740,000 7,400 2,074,057 (2,081,457) -

Amortization of deferredstock com-pensation 831,626 831,626

Exercise of options byemployees 897,248 8,972 1,101,172 1,110,144

Exercise of options byconsultants 37,615 376 50,799 51,175

Issuance of shares inrespect of FAACacquisition

1,003,856 10,039 1,993,639 2,003,678 Accrued interest on notes

receivable fromstockholders

18,990 (18,990) - Other comprehensive

income - foreigncurrency translationadjustment

263,404 $ 263,404 263,404

Other comprehensiveincome - realized gainon available for salemarketable securities

4,502 4,502 4,502

Net loss (9,042,313) (9,042,313) (9,042,313)

$ (8,774,407) Balance as of December

31, 2004 80,576,902 $ 805,769 $ 189,266,704 $ (118,953,553) $ (1,258,295) $ (3,537,106) $ (1,222,871) $ 372,335 $ 65,472,983


F-11

AROTECH CORPORATION AND ITS SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS

In U.S. dollars

Year ended December 31, 2004 2003* 2002 Cash flows from operating activities:

Net loss $ (9,042,313) $ (9,237,621) $ (18,504,358)Less loss (profit) for the period from discontinued operations - (110,410) 13,566,206

Adjustments required to reconcile net loss to net cash used in operating activities: Minorities interests in earnings (loss) of subsidiary 44,694 (156,900) 355,360 Depreciation 1,199,465 730,159 473,739 Amortization of intangible assets, capitalized software costs and impairment of intangible

assets 2,888,226 879,311 623,543 Remeasurement of liability in connection to warrants granted (326,839) - - In-process research and development write-off - - 26,000 Accrued severance pay, net (441,610) 3,693 (357,808)Amortization of deferred stock compensation and compensation related to shares issued to

employees 884,826 8,286 19,000 (Mark up) write-off of loans to stockholders (32,397) (12,519) 542,317 Write-off of inventories 121,322 96,350 116,008 Impairment of property and equipment - 68,945 - Amortization of compensation related to warrants issued to the holders of convertible

debentures and beneficial conversion feature 4,142,109 3,928,237 - Amortization of deferred charges related to convertible debentures issuance 222,732 483,713 - Amortization of prepaid financial expenses - 236,250 - Stock-based compensation related to grant of new warrants and repricing of warrants granted

to consultants - 229,259 - Stock-based compensation related to shares issued and to be issued to consultants and shares

granted as a donation 89,078 161,947 - Stock-based compensation related to non-recourse note granted to stockholder (10,000) 38,500 - Interest accrued on promissory notes due to acquisition 39,311 (66,793) 29,829 Interest accrued on restricted collateral deposits (267,179) - (3,213)Capital gain from sale of marketable securities (4,247) - - Amortization of premium related to restricted held to maturity securities 202,467 - - Capital gain from sale of property and equipment (16,479) (11,504) (4,444)Decrease (increase) in trade receivables 732,828 (820,137) 389,516 (Increase) decrease in other accounts receivable and prepaid expenses (49,513) 40,520 257,218 Decrease in deferred tax assets (89,823) - - Increase in inventories (2,040,854) (193,222) (520,408)Increase in unbilled revenues (1,581,080) - -

Decrease in deferred revenues (91,271) - - Decrease in trade payables 2,913,623 (986,022) (62,536)Increase (decrease) in other accounts payable and accrued expenses (125,231) 1,677,668 (423,664)Net cash used in operating activities from continuing operations (reconciled from continuing

operations) (638,155) (3,012,290) (3,477,695)

Net cash used in operating activities from discontinued operations (reconciled fromdiscontinued operations) (214,041) (313,454) (5,456,912)

Net cash used in operating activities $ (852,196) $ (3,325,744) $ (8,934,607)

* Restated. (see Note 1.b.)


AROTECH CORPORATION AND ITS SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS

In U.S. dollars Year ended December 31, 2004 2003* 2002 Cash flows from investing activities:

Purchase of property and equipment (1,659,688) (580,949) (314,876)Increase in capitalized software costs (365,350) (209,616) - Loans granted to stockholders (1,036) (13,737) (4,529)Repayment of loans granted to stockholders 32,397 9,280 - Proceeds from sale of property and equipment 114,275 16,753 8,199 Proceeds from sale of marketable securities 90,016 - - Investment in marketable securities (89,204) - - Acquisition of IES (1) - - (2,958,083)Acquisition of MDT (2) - - (1,201,843)Acquisition of Epsilor (3) (7,190,777) - - Acquisition of FAAC (4) (12,129,103) - - Acquisition of AoA (5) (17,339,522) - - Repayment of promissory notes related to acquisition of subsidiaries (2,000,000) (750,000) - Purchase of certain tangible and intangible assets (150,000) (196,331) - Increase in restricted cash and held to maturity securities (9,809,091) (72,840) (595,341)Net cash used in discontinued operations (purchase of property and equipment) - - (290,650)

Net cash used in investing activities (50,497,083) (1,797,440) (5,357,123)Cash flows from financing activities:

Proceeds from issuance of shares, net 24,361,750 (6,900) 3,230,000

Proceeds from exercise of options to employees and consultants 1,148,819 440,914 113,350

Proceeds from exercise of warrants 19,233,271 3,296,254 - Proceeds from issuance of convertible debentures, net - 13,708,662 - Payment of interest and principal on notes receivable from stockholders - - 43,308 Profit distribution to minority - - (412,231)Long term loan received 69,638 - - Repayment of long term loan (65,674) - - Increase (decrease) in short term bank credit (376,783) (74,158) 108,659 Payment on capital lease obligation (4,145) (4,427) (5,584)

Net cash provided by financing activities 44,366,876 17,360,345 3,077,502 Increase (decrease) in cash and cash equivalents (6,982,403) 12,237,161 (11,214,228)Cash erosion due to exchange rate differences 31,790 (9,562) - Cash and cash equivalents at the beginning of the year 13,685,125 1,457,526 12,671,754 Cash and cash equivalents at the end of the year $ 6,734,512 $ 13,685,125 $ 1,457,526 Supplementary information on non-cash transactions:

Issuance of shares and warrants against accrued expenses and restricted deposit $ 1,310,394 $ - $ - Issuance of shares to consultants in respect of prepaid interest expenses $ - $ - $ 236,250

Exercise of options against notes receivable $ - $ - $ 36,500 Purchase of intangible assets against note receivable $ - $ 300,000 $ - Increase of investment in subsidiary against issuance of shares of common stock $ - $ 123,480 $ - Conversion of promissory note to shares of common stock $ - $ 450,000 $ - Conversion of convertible debenture to shares of common stock $ 3,837,500 $ 6,125,000 $ - Benefit due to convertible debentures and warrants $ - $ 10,853,043 $ -

Accrual for earn out in regard to subsidiary acquisition $ 13,435,325 $ - $ - Supplemental disclosure of cash flows activities:

Cash paid during the year for: Interest $ 532,750 $ 39,412 $ 10,640 Taxes on income $ 969,009 $ 527,053 $ 114,901



AROTECH CORPORATION AND ITS SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (Cont.)

In U.S. dollars (1) In July 2002, the Company acquired substantially all of the assets of I.E.S. Electronics Industries U.S.A., Inc. (“IES”). The net fair value of the assets acquired and the

liabilities assumed, at the date of acquisition, was as follows:

Working capital, excluding cash and cash equivalents $ 1,233,000 Property and equipment, net 396,776 Capital lease obligation (15,526)Technology 1,515,000 Existing contracts 46,000 Covenants not to compete 99,000 In process research and development 26,000 Customer list 527,000 Trademarks 439,000 Goodwill 4,032,726 8,298,976 Issuance of shares (3,653,929)Issuance of promissory note (1,686,964) $ 2,958,083

(2) In July 2002, the Company acquired 51% of the outstanding ordinary shares of MDT Protective Industries Ltd. (“MDT”). The fair value of the assets acquired andliabilities assumed, at the date of acquisition, was as follows:

Working capital, excluding cash and cash and cash equivalents $ 350,085 Property, and equipment, net 139,623 Minority rights (300,043)Technology 280,000 Customer base 285,000 Goodwill 886,255 1,640,920 Issuance of shares (439,077) $ 1,201,843

(3) In January 2004, the Company acquired substantially all of the outstanding ordinary shares of Epsilor Electronic Industries, Ltd. (“Epsilor”). The net fair value of the

assets acquired and the liabilities assumed, at the date of acquisition, was as follows: Working capital, excluding cash and cash equivalents $ (849,992)Property and equipment 709,847 Intangible assets and goodwill 10,284,407 10,144,262 Issuance of shares in respect to transaction costs (12,500)Issuance of promissory note *) (2,940,985) $ 7,190,777

*) During the year 2004 amount of $2,000,000 was repaid to the former shareholders of Epsilor.


F-14

AROTECH CORPORATION AND ITS SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (Cont.)

In U.S. dollars (4) In January 2004, the Company acquired all of the outstanding common stock of FAAC Incorporated (“FAAC”). The net fair value of the assets acquired and the liabilities

assumed at the date of acquisition was as follows:

Working capital, excluding cash and cash equivalents $ 1,796,791 Property and equipment 263,669 Intangible assets and goodwill 25,507,646 27,568,106 Accrual of earn out payment (13,435,325)Issuance of shares, net (2,003,678) $ 12,129,103

(5) In August 2004, the Company acquired all of the outstanding common stock of Armour of America, Incorporated (“AoA”). The net fair value of the assets acquired andthe liabilities assumed at the date of acquisition was as follows:

Working capital, excluding cash and cash equivalents $ 3,219,728 Property and equipment 997,148 Intangible assets and goodwill 13,122,646 $ 17,339,522


AROTECH CORPORATION AND ITS SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In U.S. dollars NOTE 1:- GENERAL a. Arotech Corporation, f/k/a Electric Fuel Corporation (“Arotech” or the “Company”) and its subsidiaries are engaged in the development, manufacture and marketing ofdefense and security products, including advanced hi-tech multimedia and interactive digital solutions for training of military, law enforcement and security personnel andsophisticated lightweight materials and advanced engineering processes to armor vehicles, and in the design, development and commercialization of its proprietary zinc-airbattery technology for electric vehicles and defense applications. The Company is primarily operating through IES Interactive Training, Inc. (“IES”), a wholly-owned subsidiarybased in Littleton, Colorado; FAAC Corporation, a wholly-owned subsidiary based in Ann Arbor, Michigan, and FAAC’s 80%-owned United Kingdom subsidiary FAACLimited; Electric Fuel Battery Corporation, a wholly-owned subsidiary based in Auburn, Alabama; Electric Fuel Ltd. (“EFL”) a wholly-owned subsidiary based in BeitShemesh, Israel; Epsilor Electronic Industries, Ltd., a wholly-owned subsidiary located in Dimona, Israel; MDT Protective Industries, Ltd. (“MDT”), a majority-ownedsubsidiary based in Lod, Israel; MDT Armor Corporation, a majority-owned subsidiary based in Auburn, Alabama; and Armour of America, Incorporated, a wholly-ownedsubsidiary based in Los Angeles, California. Revenues derived from the Company’s largest customers in 2004, 2003 and 2002 are described in Note 18.

b. Restatement of previously-issued financial statements: During management’s review of the Company’s interim financial statements for the period ended September 30, 2004 the Company, after discussion with and based on a newand revised review of accounting treatment by its independent auditors, conducted a comprehen-sive review of the re-pricing of warrants and grant of new warrants to certain ofits investors and others during 2003 and 2004. As a result of that review, the Company, upon recommendation of management and with the approval of the Audit Committee ofthe Board of Directors after discussion with the Company’s independent auditors, reconsidered the accounting related to these transactions and reclassified certain expenses as adeemed dividend, a non-cash item, instead of as general and administrative expenses due to the recognition of these transactions as capital transactions that should not beexpensed. These restatements do not affect the balance sheet, the stockholders’ equity or the cash flow statements. In addition and as a result of the remeasurement describedabove, the Company has reviewed assumptions used in the calculation of fair value of all warrants granted during the year 2003. and recalculated its shares’ volatility whileeliminating high fluctuation in the market price of the share in 2000 and 1999, due to certain announcements made by the Company related to the opening of its consumerbattery operations (since terminated). As a result of this comprehensive review, the Company has decreased its general and administrative expenses in the amount of $150,000,related to warrants granted in a litigation settlement. In addition, during management’s review of the Company’s interim financial statements for the period ended September 30, 2004, the Company also reviewed its calculation ofamortization of debt discount attributable to the beneficial conversion feature associated with the convertible debentures. As a result of this review, the Company found errorswhich increased its financial expenses in the amount of $568,000 for the year ended December 31, 2003. The errors were related to the amortization of debt discountattributable to the warrants and their related convertible debentures, whereby the Company understated the amount of amortization for the year ended December 31, 2003attributable to certain of the convertible debentures. See Note 13.

F-16


In U.S. dollars

NOTE 1:- GENERAL (Cont.) Similar errors were also noted in the Company’s interim financial statements in the three-month period ended June 30, 2003, the nine-month period ended September 30, 2003,and the three and six-month periods ended March 31 and June 30, 2004. The annual and quarterly impacts of these restatements with respect to the year ended December 31, 2003 are summarized below: Statement of Operations Data: For the Three Months ended June 30, 2004




For the Six Months ended June 30, 2004


General and administrative expenses $ 7,202,454 $ (1,742,384) $ 5,460,070 Operating loss 5,228,267 (1,742,384) 3,485,883 Financial expenses, net 3,259,530 (28,174) 3,231,356 Loss from continuing operations 8,684,570 (1,770,558) 6,914,012 Net loss 8,684,570 (1,770,558) 6,914,012

Deemed dividend to certain stockholders of common stock - 1,163,000 1,163,000 Net loss attributable to common stockholders $ 8,684,570 $ (607,558) $ 8,077,012

Basic and diluted net loss per share from continuing operations $ 0.14 $ (0.03) $ 0.11 Basic and diluted net loss per share $ 0.14 $ (0.01) $ 0.13

F-17


In U.S. dollars

NOTE 1:- GENERAL (Cont.) For the Three Months ended March 31, 2004


General and administrative expenses $ 3,680,993 $ (1,592,857) $ 2,088,136 Operating loss 3,036,562 (1,592,857) 1,443,705 Financial expenses, net 1,273,954 (195,409) 1,078,545 Loss from continuing operations 4,306,155 (1,788,266) 2,517,889 Net loss 4,306,155 (1,788,266) 2,517,889

Deemed dividend to certain stockholders of common stock - 1,163,000 1,163,000 Net loss attributable to common stockholders $ 4,306,155 $ (625,266) $ 3,680,889

Basic and diluted net loss per share from continuing operations $ 0.07 $ (0.03) $ 0.04 Basic and diluted net loss per share $ 0.07 $ (0.01) $ 0.06

For the Year ended December 31, 2003





F-18


In U.S. dollars

NOTE 1:- GENERAL (Cont.)

For the Nine Months ended September 30, 2003


General and administrative expenses $ 3,579,371 $ (123,085) $ 3,456,286 Operating loss 2,597,043 (123,085) 2,473,958 Financial expenses, net 1,084,582 129,000 1,213,582 Net income from continuing operations 3,854,949 5,915 3,860,864 Net loss 3,774,066 5,915 3,779,981



For the Three Months ended September 30, 2003


General and administrative expenses $ 1,105,864 $ (123,085) $ 982,779 Operating income 234,428 123,085 357,513 Financial expenses, net 100,761 (18,428) 82,333 Net income from continuing operations 77,093 141,513 218,606 Net income 74,808 141,513 216,321

Deemed dividend to certain stockholders of common stock - (94,676) (94,676)Net income attributable to common stockholders $ 74,808 $ 46,837 $ 121,645

Basic and diluted net earnings per share from continuing operations $ 0.00 $ 0.00 $ 0.00 Basic and diluted net earnings per share $ 0.00 $ 0.00 $ 0.00

F-19


In U.S. dollars

NOTE 1:- GENERAL (Cont.) For the Six Months ended June 30, 2003


Financial expenses, net $ 983,821 $ 147,428 $ 1,131,249 Loss from continuing operations 3,932,041 147,428 4,079,469 Net loss 3,848,875 147,428 3,996,303



For the Three Months ended June 30, 2003


Financial expenses, net $ 725,609 $ 147,428 $ 873,037 Loss from continuing operations 2,640,920 147,428 2,788,348 Net loss 2,461,793 147,428 2,609,221



Balance sheet data: As of June 30, 2004


Convertible debenture $ 737,235 $ 540,075 $ 1,277,310 Total long term liabilities 6,278,225 540,075 6,818,300 Additional paid in capital 167,789,043 (2,081,287) 165,707,756 Accumulated deficit (118,366,463) 1,541,212 (116,825,257)Total shareholders’ equity 44,707,225 (540,075) 44,167,150

F-20


In U.S. dollars

NOTE 1:- GENERAL (Cont.) As of March 31, 2004


Convertible debenture $ 849,037 $ 372,841 $ 1,221,878 Total long term liabilities 6,062,891 372,841 6,435,732 Additional paid in capital 162,331,180 (1,931,760) 160,399,420 Accumulated deficit (113,988,048) 1,558,919 (112,429,129)Total shareholders’ equity 44,019,328 (372,841) 43,646,487

As of December 31, 2003


Other accounts payable and accrued expenses $ 4,180,411 $ (150,000) $ 4,030,411 Convertible debenture 881,944 568,250 1,450,194 Total long term liabilities 4,066,579 568,250 4,634,829 Additional paid in capital 135,891,316 (188,903) 135,702,413 Accumulated deficit (109,681,893) (229,347) (109,911,240)Total shareholders’ equity 22,044,127 (418,250) (21,625,877)

As of September 30, 2003


Convertible debenture $ 1,115,001 $ 129,000 $ 1,244,001 Total long term liabilities 4,178,147 129,000 4,307,147 Additional paid in capital 120,105,276 (123,085) 119,982,191 Accumulated deficit (104,447,685) (5,915) (104,453,600)Total shareholders’ equity 11,411,175 (129,000) 11,282,175

As of June 30, 2003


Convertible debenture $ 988,572 $ 147,428 $ 1,136,000 Total long term liabilities 4,358,568 147,428 4,505,996 Accumulated deficit (104,522,494) (147,428) (104,669,922)Total shareholders’ equity 10,356,181 (147,428) 10,208,753

F-21


In U.S. dollars

NOTE 1:- GENERAL (Cont.)

Cash flow data: For the Six Months ended June 30, 2004


Net loss $ 8,684,570 $ (1,770,558) $ 6,914,012 Stock based compensation related to repricing of warrants granted to investors and the grant of

new warrants 1,742,384 (1,742,384) -

Amortization of compensation related to beneficial conversion feature and warrants issued toholders of convertible debentures 2,967,791 (28,174) 2,939,617

For the Three Months ended March 31, 2004


Net loss $ 4,306,155 $ (1,788,266) $ 2,517,889 Stock based compensation related to repricing of warrants granted to investors and the grant of

new warrants 1,592,857 (1,592,857) -

Amortization of compensation related to beneficial conversion feature and warrants issued toholders of convertible debentures 1,117,093 (195,409) 921,684

For the Year ended December 31, 2003


Net loss $ 9,008,274 $ 229,347 $ 9,237,621 Stock based compensation related to repricing of warrants granted to investors and the grant of

new warrants 388,403 (188,903) 199,500

Amortization of compensation related to beneficial conversion feature and warrants issued toholders of convertible debentures 3,359,987 568,250 3,928,237

F-22


In U.S. dollars

NOTE 1:- GENERAL (Cont.) For the Nine Months ended September 30, 2003


Net loss $ 3,774,066 $ 5,915 $ 3,779,981 Stock based compensation related to repricing of warrants granted to investors and the grant of

new warrants 152,844 (123,085) 29,759

Amortization of compensation related to beneficial conversion feature and warrants issued toholders of convertible debentures 1,005,001 129,000 1,134,001

For the Six Months ended June 30, 2003


Net loss $ 3,848,875 $ 147,428 $ 3,996,303

Amortization of compensation related to beneficial conversion feature and warrants issued toholders of convertible debentures 878,572 147,428 1,026,000

c. Acquisition of Epsilor: In January 2004, the Company entered into a stock purchase agreement between itself and all of the shareholders of Epsilor Electronic Industries, Ltd. (“Epsilor”), pursuant tothe terms of which the Company purchased all of the outstanding shares of Epsilor from Epsilor’s existing shareholders. Epsilor develops and sells rechargeable and primarylithium batteries and smart chargers to the military, and to private industry in the Middle East, Europe and Asia. The Acquisition was accounted under the purchase method accounting. Accordingly, all assets and liabilities acquired were recorded at their estimated market values as of thedate of acquisition, and results of Epsilor’s operations have been included in the consolidated financial statements commencing the date of acquisition. The total consideration of$10,144,262 (including transaction costs) for the shares purchased consisted of (i) cash in the amount of $7,000,000, and (ii) a series of three $1,000,000 promissory notes, dueon the first, second and third anniversaries of the agreement, which were recorded at their fair value of $2,940,985. Based upon a valuation of tangible and intangible assets acquired, Arotech has allocated the total cost of the acquisition to Epsilor’s net assets as follows:

F-23


In U.S. dollars

NOTE 1:- GENERAL (Cont.) Tangible assets acquired 2,239,848 Intangible assets

Customer list 5,092,395 Goodwill 5,192,012

Liabilities assumed (2,379,993)

Total consideration $ 10,144,262 Customer list in the amount of $5,092,395 has a useful life of approximately ten years. The nature of this acquisition involved a company whose primary assets were intangible - trademarks, intellectual property, such as technology and know-how, and its broadcustomer base. Once these assets were valued, the remainder of the purchase price over the tangible and other intangible assets was attributed to goodwill (which includesworkforce). By purchasing Epsilor, the Company gained potential customers (i.e., its customer base) due to Epsilor’s very high reputation in its market. Additionally, Epsilor’sreputation in the industry and its name recognition are also factors in the valuation of Epsilor’s goodwill. Accordingly, the acquisition resulted in a significant allocation togoodwill due to the above factors. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill arising from acquisitions will not be amortized. In lieu of amortization, Arotech isrequired to perform an annual impairment test. If Arotech determines, through the impairment review process, that goodwill has been impaired, it will record the impairmentcharge in its statement of operations. Arotech will also assess the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may notbe recoverable. The value assigned to tangible, intangible assets and liabilities was determined as follows:

1. To determine the estimated market value of Epsilor’s net current assets, property and equipment, and net liabilities, the “Cost Approach” was used. According to thevaluation made, the book values for the current assets and liabilities were reasonable proxies for their market values.

2. The customer list is the asset that generates most of the Company’s sales. Hence, the “Income Approach” was used to estimate its value, resulting in a value of

$5,092,395. See Note 1.h. for pro forma financial information. d. Acquisition of FAAC: In January of 2004, the Company entered into a stock purchase agreement with the stockholders of FAAC Incorporated (“FAAC”), pursuant to the terms of which it acquired allof the issued and outstanding common stock of FAAC, a provider of driving simulators, systems engineering and software products to the United States military, governmentand private industry.

F-24


In U.S. dollars

NOTE 1:- GENERAL (Cont.) The Acquisition was accounted under the purchase method accounting. Accordingly, all assets and liabilities were recorded at their estimated market values as of the dateacquired, and results of FAAC’s operations have been included in the consolidated financial statements commencing the date of acquisition. The consideration for the purchaseconsisted of (i) cash in the amount of $12.0 million, and (ii) the issuance of a total of 1,003,856 shares of our common stock, $0.01 par value per share, having a value ofapproximately $2.0 million. Additionally, there is an earn-out based on 2004 net pretax income, with an additional earn-out on the 2005 pretax income from certain specific andlimited programs. Based on FAAC’s 2004 net pretax income, the Company estimates its earn-out obligation at $13.4 million, of which $6.0 million was pre-paid into escrow inthe form of restricted cash (See Note 3). In March 2005, the Company and the former stockholders of FAAC signed an agreement pursuant to which the Company will transferthe restricted cash to the former stockholders of FAAC by March 31, 2005, and will issue to the former stockholders of FAAC $10.0 million in Arotech stock by April 30,2005, with such stock to be registered and sold on behalf of the former stockholders of FAAC by March 31, 2006 until the earn-out shall have been paid in full (with anyremaining shares of Arotech stock after proceeds of the sales reach $7.4 million to be returned to the Company) ; should the proceeds of the sales be less than $7.4 million, theCompany will pay any shortfall in cash). The total consideration of $27.6 million (including the earn-out as well as $135,131 of transaction costs) was determined based uponarm’s-length negotiations between the Company and FAAC’s stockholders. Based upon a valuation of tangible and intangible assets acquired, Arotech has allocated the total cost of the acquisition to FAAC’s assets and liabilities as follows: Tangible assets acquired $ 4,833,553 Intangible assets

Technology 4,610,000 Backlog 636,000 Customer list 1,125,000 Trademarks 374,000 Goodwill 18,762,646

Liabilities assumed (2,770,843)

Total consideration $ 27,570,356 Intangible assets which are subject to amortization, excluding trademarks, which are not subject to amortization, in the amount of $6,371,000 have a weighted-average usefullife of approximately eight years. The nature of this acquisition involved a company whose primary assets were intangible - trademarks, intellectual property, such as technology and know-how, and its broadcustomer base. Once these assets were valued, the remainder of the purchase price over the tangible and other intangible assets was attributed to goodwill (which includesworkforce). By purchasing FAAC, the Company gained valuable government contacts. In addition, the Company believed it would gain the ability to increase sales of both itstraditional products and the new products gained from the acquisition by cross selling into each other’s established markets. Synergies may also be realized through the use ofsome common corporate overhead resources. Additionally, FAAC’s reputation in the industry and its name recognition are also factors in the valuation of FAAC’s goodwill.Accordingly, the acquisition resulted in a significant allocation to goodwill due to the above factors.

F-25


In U.S. dollars

NOTE 1:- GENERAL (Cont.) In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill arising from acquisitions will not be amortized. In lieu of amortization, Arotech isrequired to perform an annual impairment test. If Arotech determines, through the impairment review process, that goodwill has been impaired, it will record the impairmentcharge in its statement of operations. Arotech will also assess the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may notbe recoverable.

The value assigned to tangible, intangibles assets and liabilities was determined as follows:

1. To determine the estimated fair value of FAAC’s net current assets, property and equipment, and net liabilities, the “Cost Approach” was used. According to thevaluation made, the book values for the current assets and liabilities were reasonable proxies for their market values.

2. The amount of the cost attributable to technology of the software, documentation and know-how that drives the vehicle simulators and the high-speed missile fly-out

simulators is $4,610,000 and was determined using the “Income Approach.”

3. FAAC’s sales are all made on a contractual basis, most of which are over a relatively long period of time. At the date of the purchase FAAC had several signedcontracts at various stages of completion. The value of the existing contracts was determined using the Income approach and resulting in a value of $636,000.

4. FAAC’s customer list includes various branches of the U.S. military, major defense contractors, various city and country governments and others. Since customer

relationship represent one of the most important revenue generating assets for FAAC, its value was estimated using the Income Approach, resulting in a value of$1,125,000.

5. FAAC’s trade name value represents the name recognition value of the FAAC brand name as a result of advertising spending by the company. The Cost Approach

was used to determine the value of FAAC’s trade name in the amount of $374,000. See Note 1.h. for pro forma financial information. e. Acquisition of AoA: I n August 2004, the Company purchased all of the outstanding stock of Armour of America, Incorporated, a California corporation (“AoA”), from AoA’s existingshareholder. The assets acquired through the purchase of all of AoA’s outstanding stock consisted of all of AoA’s assets, including AoA’s current as-sets, property andequipment, and other assets (including intangible assets such as in-tellectual property and contractual rights).

F-26


In U.S. dollars

NOTE 1:- GENERAL (Cont.) The total purchase price consisted of $19,000,000 in cash, with additional possible earn-outs if AoA is awarded certain material contracts. An additional $3,000,000 was to bepaid into an escrow account pursuant to the terms of an escrow agreement, to secure a portion of the Earnout Consideration. Pursuant to the purchase agreement, the totalconsideration, sale price plus Earnout Consideration, will not be in excess of $40,000,000. When the contingency on the earn-out provision is resolved, the additionalconsideration, if any, will be recorded as additional purchase price. The purchase price also included $121,192 of transaction costs. The transaction has been accounted for usingthe purchase method of accounting, and accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based upon their fair values at the datethe acquisition was completed. Based upon a valuation of tangible and intangible assets acquired, Arotech has allocated the total cost of the acquisition to AoA’s assets and liabilities as follows : Tangible assets acquired 6,346,316 Intangible assets

Certifications 246,969 Backlog 1,512,000 Customer relationships 490,000 Tradename /Trademark 70,000 Covenants not to compete 260,000 Goodwill 10,543,677

Liabilities assumed (347,770)

Total consideration $ 19,121,192 Intangible assets, excluding trademarks, which are not subject to amortization, in the amount of $2,508,969 have a weighted-average useful life of approximately two years. The nature of this acquisition involved a company whose primary assets were intangible - trademarks, intellectual property, such as technology and know-how, and its broadcustomer base. Once these assets were valued, the remainder of the purchase price over the tangible and other intangible assets was attributed to goodwill (which includesworkforce). By purchasing AoA, the Company was able to purchase an armoring firm in a fragmented market, enter the U.S. military sales market and save time and effort indeveloping U.S. government relationships by themselves. Further, the Company expected to cross-sell some its products to AoA’s customers and sell some of AoA’s products toits customers. Additionally, AoA’s reputation in the industry and its name recognition are also factors in the valuation of AoA’s goodwill. Accordingly, there was a significantallocation to goodwill due to the above factors. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill arising from acquisitions will not be amortized. In lieu of amortization, Arotech isrequired to perform an annual impairment test. If Arotech determines, through the impairment review process, that goodwill has been impaired, it will record the impairmentcharge in its statement of operations. Arotech will also assess the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may notbe recoverable.

F-27


In U.S. dollars

NOTE 1:- GENERAL (Cont.) See Note 1.h. for pro forma financial information. f. Acquisition of IES: I n August 2, 2002, the Company entered into an asset purchase agreement among I.E.S. Electronics Industries U.S.A., Inc. (“IES”), its direct and certain of its indirectshareholders, and its wholly-owned Israeli subsidiary, EFL, pursuant to the terms of which it acquired substantially all the assets, subject to substantially all the liabilities, ofIES, a developer, manufacturer and marketer of advanced hi-tech multimedia and interactive digital solutions for training of military, law enforcement and security personnel.The Company intends to continue to use the assets purchased in the conduct of the business formerly conducted by IES (the “Business”). The acquisition has been accountedunder the purchase method of accounting. Accordingly, all assets and liabilities were acquired as at the values on such date, and the Company consolidated IES’s results with itsown commencing at such date. The assets purchased consisted of the current assets, property and equipment, and other intangible assets used by IES in the conduct of the Business. The consideration for theassets and liabilities purchased consisted of (i) cash and promissory notes in an aggregate amount of $4,800,000 ($3,000,000 in cash and $1,800,000 in promissory notes, whichwas recorded at its fair value in the amount of $1,686,964) (see Note 10), and (ii) the issuance, with registration rights, of a total of 3,250,000 shares of our common stock, $.01par value per share, having a value of approximately $3,653,929, which shares are the subject of a voting agreement on the part of IES and certain of its affiliated companies.The value of 3,250,000 shares issued was determined based on the average market price of Arotech’s Common stock over the period including two days before and after theterms of the acquisition were agreed to and announced. The total consideration of $8,354,893 (including $14,000 of transaction costs) was determined based upon arm’s-lengthnegotiations between the Company and IES and IES’s shareholders. Based upon a valuation of tangible and intangible assets acquired, Arotech has allocated the total cost of the acquisition to IES’s assets as follows: Tangible assets acquired $ 2,856,951 Intangible assets

Technology 1,515,000 Existing contracts 46,000 Covenants not to compete 99,000

In process research and development 26,000 Customer 527,000

Trademarks 439,000 Goodwill 4,032,726

Liabilities assumed (1,186,784) Total consideration $ 8,354,893

F-28


In U.S. dollars

NOTE 1:- GENERAL (Cont.) In September 2003, the Company’s IES subsidiary purchased selected assets of Bristlecone Corporation. The assets purchased consisted of inventories, customer lists, andcertain other assets (including intangible assets such as intellectual property and customer lists), including the name “Bristlecone Training Products” and the patents for theHeads Up Display (HUD) and a remote trigger device, used by Bristlecone in connection with its designing and manufacturing firearms training devices, for a totalconsideration of $183,688 in cash and $300,000 in promissory notes, payable in four equal semi-annual payments of $75,000 each, to become due and payable on March 1,2004, August 31, 2004, February 28, 2005 and August 31, 2005. The acquired patents are used in the IES’s Range FDU (firearm diagnostics unit). The purchase consideration was estimated as follows: Cash consideration $ 183,688 Present value of promissory notes 289,333 Transaction expenses 12,643 Total consideration $ 485,664 Based upon a valuation of tangible and intangible assets acquired, the Company has allocated the total cost of the acquisition of Bristlecone’s assets as follows: Tangible assets acquired $ 33,668 Intangible assets

Technology and patents 436,746 Customer list 15,250

Total consideration $ 485,664 The Company believes that the acquisition of Bristlecone is not material to its business. g. Acquisition of MDT: On July 1, 2002, the Company entered into a stock purchase agreement with all of the shareholders of M.D.T. Protective Industries Ltd. (“MDT”), pursuant to the terms ofwhich the Company purchased 51% of the issued and outstanding shares of MDT, a privately-held Israeli company that specializes in using sophisticated lightweight materialsand advanced engineering processes to armor vehicles. The Company also entered into certain other ancillary agreements with MDT and its shareholders and other affiliatedcompanies. The Acquisition was accounted under the purchase method accounting and results of MDT’s operations have been included in the consolidated financial statementssince that date. The total consideration of $1,767,877 for the shares purchased consisted of (i) cash in the aggregate amount of 5,814,000 New Israeli Shekels ($1,231,780), and(ii) the issuance, with registration rights, of an aggregate of 390,638 shares of our common stock, $0.01 par value per share, having a value of approximately $439,077. Thevalue of 390,638 shares issued was determined based on the average market price of Arotech’s Common stock over the period including two days before and after the terms ofthe acquisition were agreed to and announced.

F-29


In U.S. dollars

NOTE 1:- GENERAL (Cont.) Based upon a valuation of tangible and intangible assets acquired, Arotech has allocated the total cost of the acquisition to MDT’s assets as follows: Tangible assets acquired $ 1,337,048 Intangible assets

Technology 280,000 Customer base 285,000 Goodwill 886,255

Liabilities assumed (1,020,426)Total consideration $ 1,767,877

In September 2003, the Company increased its holdings in both of its vehicle armoring subsidiaries. The Company now holds 88% of MDT Armor Corporation (compared to76% before this transaction) and 75.5% of MDT Protective Industries Ltd. (compared to 51% before this transaction). The Company acquired the additional stake in MDT fromAGA Means of Protection and Commerce Ltd. in exchange for the issuance to AGA of 126,000 shares of its common stock, valued at $0.98 per share based on the closing priceof the Company’s common stock on the closing date of September 4, 2003, or a total of $123,480. Of this amount, a total of $75,941 was allocated to intangible assets. TheCompany did not obtain a valuation due to the immaterial nature of this acquisition. h. Pro forma results: In January 2004, the Company acquired FAAC and Epsilor, as more fully described in “Note 1.c. - Acquisition of Epsilor” and “Note 1.d. - Acquisition of FAAC,” above, inAugust 2004, the Company acquired AoA, as more fully described in “Note 1.e. - Acquisition of AoA,” above (the “Acquisitions”) and in the year 2002 the Company acquiredIES and MDT as more fully described in Note 1.f and Note 1.g (the “2002 Acquisitions”). The following summary pro forma information includes the effects of theAcquisitions on the operating results of the Company. The following unaudited pro forma data for 2004 and 2003 are presented as if the Acquisitions had been completed onJanuary 1, 2004 and 2003, respectively. The unaudited pro forma data for 2002 are presented as if 2002 Acquisitions had been completed on January 1, 2002. This pro forma financial information does not purport to be indicative of the results of operations that would have occurred had the Acquisitions taken place at the beginning ofthe period, nor do they purport to be indicative of the results of operations that will be obtained in the future.

F-30


In U.S. dollars

NOTE 1:- GENERAL (Cont.) Year Ended December 31, 2004 2003* 2002 (Unaudited) Total revenues $ 61,086,697 $ 39,680,394 $ 12,997,289 Gross profit 22,528,254 17,214,249 4,424,952 Net loss (5,810,114) (6,959,174) (6,103,771)

Deemed dividend of common stock attributable to certain stockholders (3,328,952) (350,000) - Net loss attributable to stockholders of common stock $ (9,139,066) $ (7,309,174) $ (6,103,771)

Basic and diluted net loss per share $ (0.13) $ (0.14) $ (0.18)

Weighted average number of shares used in computing basic net loss per share 69,933,057 52,966,330 34,495,185

* Restated. i. Discontinued operations: In September 2002, the Company committed to a plan to discontinue the operations of its retail sales of consumer battery products. The Company ceased the operation anddisposed of all assets related to this segment by an abandonment. The operations and cash flows of consumer battery business have been eliminated from the operations of theCompany as a result of the disposal transactions. The Company has no intent of continuing its activity in the consumer battery business. The Company’s plan of discontinuanceinvolved (i) termination of all employees whose time was substantially devoted to the consumer battery line and who could not be used elsewhere in the Company’s operations,including payment of all statutory and contractual severance sums, by the end of the fourth quarter of 2002, and (ii) disposal of the raw materials, equipment and inventory usedexclusively in the consumer battery business, since the Company has no reasonable expectation of being able to sell such raw materials, equipment or inventory for any sumsubstantially greater than the cost of disposal or shipping, by the end of the first quarter of 2003. The Company had previously reported its consumer battery business as aseparate segment (Consumer Batteries) as called for by Statement of Financial Standards No. 131, “Disclosures About Segments of an Enterprise and Related Information”(“SFAS No. 131”). The results of operations including revenue, operating expenses, other income and expense of the retail sales of consumer battery products business unit for 2003 and 2002 havebeen reclassified in the accompanying statements of operations as a discontinued operation. The Company’s balance sheets at December 31, 2003 reflect the net liabilities of theretail sales of consumer battery products business as net liabilities and net assets of discontinued operation within current liabilities and current assets. At December 31, 2002, the estimated net losses associated with the disposition of the retail sales of consumer battery products business were $13,566,206 for 2002. These lossesincluded approximately $6,508,522 in losses from operations for the period from January 1, 2002 through the measurement date of December 31, 2002 and $7,057,684,reflecting a write-down of inventory and net property and equipment of the retail sales of consumer battery products business, as follows:

F-31


In U.S. dollars

NOTE 1:- GENERAL (Cont.) December 31, 2002 Write-off of inventories $ 2,611,000 Impairment of property and equipment 4,446,684 $ 7,057,684 As a result of the discontinuance of consumer battery segment, the Company ceased to use property and equipment related to this segment. In accordance with Statement ofFinancial Accounting Standard No. 144 “Accounting for the Impairment or Disposal of Long- Lived Assets” (“SFAS No. 144”) such assets was considered to be impaired. Theimpairment to be recognized was measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Obligations to employees for severance and other benefits resulting from the discontinuation have been reflected in the financial statements on an accrual basis. Summary operating results from the discontinued operation for the years ended December 31, 2004, 2003 and 2002 are as follows: Year Ended December 31, 2004 2003 2002 Revenues $ - $ 117,267 $ 1,100,442 Cost of sales (1) - - (5,293,120) Gross profit (loss) - 117,267 (4,192,678)Operating expenses, net - 6,857 4,926,844 Impairment of fixed assets - - 4,446,684 Operating profit (loss) $ - $ 110,410 $ (13,566,206)

(1) Including write-off of inventory in the amount of $0, $0 and $2,611,000 for the years ended December 31, 2004, 2003 and 2002. NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”). a. Use of estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect theamounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. b. Financial statements in U.S. dollars: A majority of the revenues of the Company and most of its subsidiaries is generated in U.S. dollars. In addition, a substantial portion of the Company’s and most of itssubsidiaries costs are incurred in U.S. dollars (“dollar”). Management believes that the dollar is the primary currency of the economic environment in which the Company andmost of its subsidiaries operate. Thus, the functional and reporting currency of the Company and most of its subsidiaries i s the dollar. Accordingly, monetary accountsmaintained in currencies other than the U.S. dollar are remeasured into U.S. dollars in accordance with Statement of Financial Accounting Standards No. 52 “Foreign CurrencyTranslation” (“SFAS No. 52”). All transaction, gains and losses from the remeasured monetary balance sheet items are reflected in the consolidated statements of operations asfinancial income or expenses, as appropriate.

F-32


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The majority of transactions of MDT and Epsilor are in New Israel Shekel (“NIS”) and a substantial portion of MDT’s and Epsilor’s costs is incurred in NIS. Managementbelieves that the NIS is the functional currency of MDT and Epsilor. Accordingly, the financial statements of MDT and Epsilor have been translated into U.S. dollars. Allbalance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts has been translated using the weightedaverage exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive loss in stockholders’ equity c. Principles of consolidation: The consolidated financial statements include the accounts of the Company and its wholly and majority owned subsidiaries. Intercompany balances and transactions have beeneliminated upon consolidation. d. Cash equivalents: Cash equivalents are short-term highly liquid investments that are readily convertible to cash with maturities of three months or less when acquired.

F-33


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) e. Restricted collateral deposits Restricted cash is primarily invested in highly liquid deposits, held-to-maturity marketable securities and long-term deposits, which are used as a security for the Company’sguarantee performance and its liability to former shareholders of its acquired subsidiaries. f. Marketable securities The Company and its subsidiaries account for investments in debt and equity securities in accordance with Statement of Financial Accounting Standard No. 115, “Accountingfor Certain Investments in Debt and Equity Securities” (“SFAS No. 115”). Management determines the appropriate classification of its investments in debt and equity securitiesat the time of purchase and reevaluates such determinations at each balance sheet date. At December 31, 2004 the Company and its subsidiaries classified its investment in marketable securities as held-to-maturity and available-for-sale. Debt securities are classified as held-to-maturity, when the Company has the positive intent and ability to hold the securities to maturity, and are stated at amortized cost. Thecost of held-to-maturity securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization, accretion and interest are included infinancial income, net. Investment in trust funds are classified as available-for-sale and stated at fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss),a separate component of stockholders’ equity, net of taxes. Realized gains and losses on sales of investments, as determined on a specific identification basis, are included in theconsolidated statements of income. g. Inventories: Inventories are stated at the lower of cost or market value. Inventory write-offs and write-down provisions are provided to cover risks arising from slow-moving items ortechnological obsolescence and for market prices lower than cost. The Company periodically evaluates the quantities on hand relative to current and historical selling prices andhistorical and projected sales volume. Based on this evaluation, provisions are made to write inventory down to its market value. In 2002, 2003 and 2004, the Company wroteoff $116,008, $96,350 and $121,322 of obsolete inventory respectively, which has been included in the cost of revenues. Cost is determined as follows: Raw and packaging materials - by the average cost method. Work in progress - represents the cost of manufacturing with additions of allocable indirect manufacturing cost. Finished products - on the basis of direct manufacturing costs with additions of allocable indirect manufacturing costs.

F-34


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) h. Property and equipment: Property and equipment are stated at cost net of accumulated depreciation and investment grants (no investment grants were received during 2004, 2003 and 2002). Depreciation is calculated by the straight-line method over the estimated useful lives of the assets, at the following annual rates: %

Computers and related equipment 33Motor vehicles 15Office furniture and equipment 6 - 10Machinery and equipment 10 - 25 (mainly 10)Leasehold improvements By the shorter of the term of the lease and the life of the asset i. Goodwill: Goodwill represents the excess of cost over the fair value of the net assets of businesses acquired. Under Statement of Financial Accounting Standard No. 142, “Goodwill andOther Intangible Assets” (“SFAS No, 142”) goodwill acquired in a business combination on or after July 1, 2001, is not amortized after January 1, 2002. SFAS No. 142 requires goodwill to be tested for impairment on adoption of the Statement and at least annually thereafter or between annual tests in certain circumstances, andwritten down when impaired, rather than being amortized as previous accounting standards required. Goodwill is tested for impairment by comparing the fair value of theCompany’s reportable units with their carrying value. Fair value is determined using discounted cash flows. Significant estimates used in the methodologies include estimates offuture cash flows, future short-term and long-term growth rates, weighted average cost of capital and estimates of market multiples for the reportable units. The Company performed the required annual impairment test of goodwill. Based on the management projections and using expected future discounted operating cash flows, noindication of goodwill impairment was identified. j. Long-lived assets: Intangible assets acquired in a business combination that are subject to amortization are amortized over their useful life using a method of amortization that reflects the pattern inwhich the economic benefits of the intangible assets are consumed or otherwise used up, in accordance with SFAS No. 142. The acquired trademarks and tradenames are deemed to have an indefinite useful life because they are expected to contribute to cash flows indefinitely. Therefore, thetrademarks will not be amortized until their useful life is no longer indefinite. The trademarks and tradenames are tested annually for impairment in accordance FAS 142.

F-35


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The Company and its subsidiaries’ long-lived assets and certain identifiable intangibles are reviewed for impairment in accordance with Statement of Financial AccountingStandard No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”) whenever events or changes in circumstances indicate that the carryingamount of an asset may not be recoverable. Recoverability of the carrying amount of assets to be held and used is measured by a comparison of the carrying amount of theassets to the future undiscounted cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured bythe amount by which the carrying amount of the assets exceeds the fair value of the assets. As of December 31, 2004 the Company identified an impairment of the technologypreviously purchased from Bristlecone and as a result has recorded an impairment loss in the amount of $320,000. k. Revenue recognition: The Company is a defense and security products and services company, engaged in three business areas: interactive simulation for military, law enforcement and commercialmarkets; batteries and charging systems for the military; and high-level armoring for military, paramilitary and commercial vehicles. During 2004, the Company and itssubsidiaries recognized revenues as follows: (i) from the sale and customization of interactive training systems and from the maintenance services in connection with suchsystems (Interactive Training Division); (ii) from revenues under armor contracts and for service and repair of armored vehicles (Armoring Division); (iii) from the sale ofbatteries, chargers and adapters to the military, and under certain development contracts with the U.S. Army (Battery Division); and (iv) from the sale of lifejacket lights(Battery Division. Revenues from the Battery division products and Armoring division are recognized in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” whenpersuasive evidence of an agreement exists, delivery has occurred, the fee is fixed or determinable, collectability is probably, and no further obligation remains. Revenues from products not delivered upon customers’ request due to lack of storage space at the customers’ facilities during the integration are recognized when the criteria ofStaff Accounting Bulletin No. 104 (“SAB No. 104”) for bill-and-hold transactions are met. Revenues from contracts that involve customization of FAAC’s simulation system to customer specific specifications are recognized in accordance with Statement Of Position81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” using contract accounting on a percentage of completion method, inaccordance with the “Input Method.” The amount of revenue recognized is based on the percentage to completion achieved. The percentage to completion is measured bymonitoring progress using records of actual time incurred to date in the project compared to the total estimated project requirement, which corresponds to the costs related toearned revenues. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and arereviewed and updated regularly by management. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are first determined, in theamount of the estimated loss on the entire contract. As of December 31, 2004 no such estimated losses were identified.

F-36


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The Company believes that the use of the percentage of completion method is appropriate as the Company has the ability to make reasonably dependable estimates of the extentof progress towards completion, contract revenues and contract costs. In addition, contracts executed include provisions that clearly specify the enforceable rights regardingservices to be provided and received by the parties to the contracts, the consideration to be exchanged and the manner and the terms of settlement, including in cases ofterminations for convenience. In all cases the Company expects to perform its contractual obligations and its customers are expected to satisfy their obligations under thecontract.

Revenues from simulators, which do not require significant customization, are recognized in accordance with Statement of Position 97-2, “Software Revenue Recognition,”(“SOP 97-2”). SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fairvalue of the elements. The Company has adopted Statement of Position 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions”(“SOP 98-9”). According to SOP No. 98-9, revenues are allocated to the different elements in the arrangement under the “residual method” when Vendor Specific ObjectiveEvidence (“VSOE”) of fair value exists for all undelivered elements and no VSOE exists for the delivered elements. Under the residual method, at the outset of the arrangementwith the customer, the Company defers revenue for the fair value of its undelivered elements (maintenance and support) and recognizes revenue for the remainder of thearrangement fee attributable to the elements initially delivered in the arrangement (software product) when all other criteria in SOP 97-2 have been met.

Revenue from such simulators is recognized when persuasive evidence of an agreement exists, delivery has occurred, no significant obligations with regard to implementationremain, the fee is fixed or determinable and collectibility is probable.

Maintenance and support revenue included in multiple element arrangements is deferred and recognized on a straight-line basis over the term of the maintenance and supportservices. Revenues from training are recognized when its performed. The VSOE of fair value of the maintenance, training and support services is determined based on the pricecharged when sold separately or when renewed. Unbilled receivables include cost and gross profit earned in excess of billing. Deferred revenues include unearned amounts received under maintenance and support services and billing in excess of costs and estimated earnings on uncompleted contracts.

F-37


In U.S. dollarsNOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) l. Right of return: When a right of return exists, the Company defers its revenues until the expiration of the period in which returns are permitted. m. Research and development cost: Research and development costs, net of grants received, are charged to the statements of operations as incurred. Software development costs incurred by the Company’s subsidiaries between completion of the working model and the point at which the product is ready for general release,are capitalized. Capitalized software costs are amortized by using the straight-line method over the estimated useful life of the product (three to five years). The Company assesses therecoverability of this intangible asset on a regular basis by determining whether the amortization of the asset over its remaining life can be recovered through future grossrevenues from the specific software product sold. Based on its most recent analyses, management identified an impairment of software development costs previously capitalizedand as a result has recorded an impairment loss in the amount of $26,000. n. Income taxes: The Company and its subsidiaries account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFASNo. 109”). This Statement prescribes the use of the liability method, whereby deferred tax assets and liability account balances are determined based on differences betweenfinancial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.The Company and its subsidiaries provide a valuation allowance, if necessary, to reduce deferred tax assets to it’s estimated realizable value. o. Concentrations of credit risk: Financial instruments that potentially subject the Company and its subsidiaries to concentrations of credit risk consist principally of cash and cash equivalents, restrictedcollateral deposit and restricted held-to-maturity securities, trade receivables and available for sale marketable securities. Cash and cash equivalents are invested mainly in U.S.dollar deposits with major Israeli and U.S. banks. Such deposits in the U.S. may be in excess of insured limits and are not insured in other jurisdictions. Management believesthat the financial institutions that hold the Company’s investments are financially sound and, accordingly, minimal credit risk exists with respect to these investments. The trade receivables of the Company and its subsidiaries are mainly derived from sales to customers located primarily in the United States, Europe and Israel. Managementbelieves that credit risks are moderated by the diversity of its end customers and geographical sales areas. The Company performs ongoing credit evaluations of its customers’financial condition. An allowance for doubtful accounts is determined with respect to those accounts that the Company has determined to be doubtful of collection.

F-38


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The Company’s available for sale marketable securities and held-to-maturity securities include investments in debentures of U.S. and Israeli corporations and state and localgovernments. Management believes that those corporations and states are institutions that are financially sound, that the portfolio is well diversified, and accordingly, thatminimal credit risk exists with respect to these marketable securities. The Company and its subsidiaries had no off-balance-sheet concentration of credit risk such as foreign exchange contracts, option contracts or other foreign hedgingarrangements. p. Basic and diluted net loss per share: Basic net loss per share is computed based on the weighted average number of shares of common stock outstanding during each year. Diluted net loss per share is computedbased on the weighted average number of shares of common stock outstanding during each year, plus dilutive potential shares of common stock considered outstanding duringthe year, in accordance with Statement of Financial Standards No. 128, “Earnings Per Share.” All outstanding stock options and warrants have been excluded from the calculation of the diluted net loss per common share because all such securities are anti-dilutive for allperiods presented. The total weighted average number of shares related to the outstanding options and warrants excluded from the calculations of diluted net loss per share was31,502,158, 22,194,211 and 4,394,803 for the years ended December 31, 2004, 2003 and 2002, respectively. q. Accounting for stock-based compensation: The Company has elected to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB No. 25”) and Interpretation No. 44“Accounting for Certain Transactions Involving Stock Compensation” in accounting for its employee stock option plans. Under APB No. 25, when the exercise price of theCompany’s share options is less than the market price of the underlying shares on the date of grant, compensation expense is recognized. Under Statement of FinancialAccounting Standard No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), pro-forma information regarding net income and net income per share isrequired, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. The Company applies SFAS No. 123 and Emerging Issue Task Force No. 96-18 “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, orin Conjunction with Selling, Goods or Services” (“EITF 96-18”) with respect to options issued to non-employees. SFAS No. 123 requires use of an option valuation model tomeasure the fair value of the options at the grant date. The fair value for the options to employees was estimated at the date of grant, using the Black-Scholes Option Valuation Model, with the following weighted-averageassumptions: risk-free interest rates of 3.63%, 2.54% and 3.5% for 2004, 2003 and 2002, respectively; a dividend yield of 0.0% for each of those years; a volatility factor of theexpected market price of the common stock of 0.81 for 2004, 0.67 for 2003 and 0.64 for 2002; and a weighted-average expected life of the option of 5 years for 2004, 2003 and2002.

F-39


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

The following table illustrates the effect on net income and earnings per share, assuming that the Company had applied the fair value recognition provision of SFASNo. 123 on its stock-based employee compensation: Year ended December 31, 2004 2003* 2002

Net loss as reported $ (9,042,313) $ (9,237,621) $ (18,504,358)Add: Stock-based compensation expenses included in reported net loss 831,626 8,286 6,000 Deduct: Stock-based compensation expenses determined under fair value methodfor all awards (2,741,463) (1,237,558) (2,072,903)

$ (10,952,150) $ (10,466,893) $ (20,571,261)

Loss per share: Basic and diluted, as reported $ (0.18) $ (0.25) $ (0.57)Diluted, pro forma $ (0.16) $ (0.27) $ (0.64)


r. Fair value of financial instruments: The following methods and assumptions were used by the Company and its subsidiaries in estimating their fair value disclosures for financial instruments: The carrying amounts of cash and cash equivalents, restricted collateral deposit and restricted held-to-maturity securities, trade receivables, short-term bank credit, and tradepayables approximate their fair value due to the short-term maturity of such instruments. The fair value of available for sale marketable securities is based on the quoted market price. Long-terms promissory notes are estimated by discounting the future cash flows using current interest rates for loans or similar terms and maturities. The carrying amount of thelong-term liabilities approximates their fair value. s. Severance pay: The Company’s liability for severance pay is calculated pursuant to Israeli severance pay law based on the most recent salary of the employees multiplied by the number ofyears of employment as of the balance sheet date. Israeli employees are entitled to one month’s salary for each year of employment, or a portion thereof. The Company’sliability for all of its employees is fully provided by monthly deposits with severance pay funds, insurance policies and by an accrual. The value of these policies is recorded asan asset in the Company’s balance sheet. In addition and according to certain employment agreements, the Company is obligated to provide for a special severance pay in addition to amounts due to certain employeespursuant to Israeli severance pay law. The Company has made a provision for this special severance pay in accordance with Statement of Financial Accounting Standard No.106, “Employer’s Accounting for Post Retirement Benefits Other than Pensions.” As of December 31, 2004 and 2003, the accumulated severance pay in that regard amountedto $1,642,801 and $1,699,260, respectively.

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In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The deposited funds include profits accumulated up to the balance sheet date. The deposited funds may be withdrawn only upon the fulfillment of the obligation pursuant toIsraeli severance pay law or labor agreements. The value of the deposited funds is based on the cash surrendered value of these policies and includes immaterial profits. Severance expenses for the years ended December 31, 2004, 2003 and 2002 amounted to $460,178, $219,857 and ($338,574) respectively. t. Advertising costs: The Company and its subsidiaries expense advertising costs as incurred. Advertising expense for the years ended December 31, 2004, 2003 and 2002 was approximately$13,271, $34,732 and $294,599, respectively. u. New accounting pronouncements: On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment,” which is a revision ofFASB Statement No. 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” andamends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However,Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fairvalues. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Companyexpects to adopt Statement 123(R) on the first interim period beginning after July 1, 2005. Statement 123(R) permits public companies to adopt its requirements using one of two methods: 1. A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement123(R) that remain unvested on the effective date.

2. A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on theamounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year ofadoption.

The Company is still in the process of evaluating the method it will use.F-41


In U.S. dollars NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generallyrecognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method will have a significant impact on our result ofoperations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will dependon levels of share-based payments granted in the future. However, had the Company adopted Statement 123(R) in prior periods, the impact of that standard would haveapproximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 2r above to the Company’s consolidatedfinancial statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather thanas an operating cash flow as required under current literature. In November 2004, the FASB issued Statement of Financial Accounting Standard No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4..” SFAS 151 amendsAccounting Research Bulletin (“ARB”) No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight handling costs and wasted materials (spoilage)should be recognized as current-period charges. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on normalcapacity of the production facilities. SAFS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company is still in the process ofthe evaluating the impact of the adoption of SFAS 151 on its financial position or results of operations. NOTE 3:- RESTRICTED COLLATERAL DEPOSITS AND RESTRICTED HELD-TO-MATURITY SECURITIES:

December 31, 2004 2003 Short-term: Restricted, held to maturity, bonds in connection with FAAC earn out (Note 1.d.)(1) $ 5,969,413 $ - IES deposit in connection to the Company’s litigation with IES Electronics Industries Ltd. - 450,000 Deposits in connection with FAAC projects 650,989 - Forward Deal - 205,489 Property lease - 41,412 Other 341,708 9,279 Total short-term 6,962,110 706,810 Long-term: Restricted cash in connection with AoA earn out (Note 1.e.) 3,000,000 - Restricted deposit in connection with Epsilor acquisition (Note 1.c.) 1,000,000 - Total long-term 4,000,000 -

$ 10,962,110

$ 706,180

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In U.S. dollars NOTE 3:- RESTRICTED COLLATERAL DEPOSIT AND OTHER RESTRICTED CASH (Cont.)

(1) The following is a summary of held-to-maturity securities at December 31, 2004 and 2003: Amortized cost Unrealized losses Estimated fair value 2004 2003 2004 2003 2004 2003

Obligations of States and political subdivisions $ 1,012,787 $ - $ (1,870) $ - $ 1,010,917 $ - Corporate obligations 4,956,626 - (11,966) - 4,944,660 -

$ 5,969,413 $ - $ (13,836) $ - $ 5,955,577 $ -

The amortized cost of held-to-maturity debt securities at December 31, 2004, by contractual maturities, is shown below:

Amortized cost Unrealized losses Estimated fair

value Due in one year or less $ 5,969,413 $ (13,836) $ 5,955,577

The unrealized losses in the Company’s investments were caused by interest rate increases. It is expected that the securities would not be settled at a price less than theamortized cost of the Company’s investment. Based on the immaterial severity of the impairments and the obligation of the Company to hold these investments until maturity,the bonds were not considered to be other than temporarily impaired at December 31, 2004. NOTE 4: - AVAILABLE FOR SALE MARKETABLE SECURITIES The following is a summary of investments in marketable securities as of December 31, 2004 and 2003: Cost Unrealized gains Estimated fair value 2004 2003 2004 2003 2004 2003 Available for sale marketable securities $ 130,061 $ - $ 5,507 $ - $ 135,568 $ - NOTE 5:- OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES

December 31, 2004 2003 Government authorities $ 433,427 $ 65,402 Employees 217,948 246,004 Prepaid expenses 490,357 551,010 Deferred taxes 135,482 - Other 62,179 324,955 $ 1,339,393 $ 1,187,371

F-43


In U.S. dollarsNOTE 6:- INVENTORIES December 31, 2004 2003 Raw and packaging materials $ 3,969,400 $ 657,677 Work in progress 1,996,139 634,221 Finished products 1,311,762 622,850 $ 7,277,301 $ 1,914,748 NOTE 7:- PROPERTY AND EQUIPMENT, NET a. Composition of property and equipment is as follows: December 31, 2004 2003 Cost:

Computers and related equipment $ 3,374,695 $ 1,015,836 Motor vehicles 653,255 288,852 Office furniture and equipment 872,804 402,726 Machinery, equipment and installations 7,464,470 4,866,904 Leasehold improvements 1,321,025 882,047 Demo inventory 141,961 150,996

13,828,210 7,607,361 Accumulated depreciation:

Computers and related equipment 2,581,689 753,593 Motor vehicles 197,071 95,434 Office furniture and equipment 494,181 173,301 Machinery, equipment and installations 5,143,186 3,637,111 Leasehold improvements 811,392 655,181

9,227,519 5,314,620 Depreciated cost $ 4,600,691 $ 2,292,741 b. Depreciation expense amounted to $1,199,465, $730,159 and $473,739, for the years ended December 31, 2004, 2003 and 2002, respectively. As for liens, see Note 12.d.

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In U.S. dollars NOTE 8:- OTHER INTANGIBLE ASSETS, NET a. Year ended December 31, 2004 2003

Cost: Technology $ 6,841,746 $ 2,231,746

Capitalized software costs 574,967 209,615 Backlog 2,194,000 46,000

Covenants not to compete 359,000 99,000 Customer list 7,548,645 827,250 Certification 246,969 -

17,765,327 3,413,611

Exchange differences 125,455 25,438 Less - accumulated amortization (4,391,081) (1,502,854)

Amortized cost 13,499,701 1,936,195 Trademarks 869,000 439,000

$ 14,368,701 $ 2,375,195

b. Amortization expenses amounted to $2,888,226, $879,311 and $623,543 for the years ended December 31, 2004, 2003 and 2002.

c. Estimated amortization expenses, except capitalized software costs, for the years ended

Year ended December 31,

2005 $ 3,280,815 2006 2,073,209 2007 1,381,883 2008 1,276,075 2009 and forward 5,000,546 $ 13,012,528 NOTE 9:- SHORT-TERM BANK CREDIT AND LOANS The Company has a $ 3.2 million authorized credit line from certain banks, of which $ 209,000 is denominated in NIS and carries an interest rate of approximately prime +2.5% and $ 3.0 million of which is denominated in dollars and carries an interest rate of prime + 0.25%. As of December 31, 2004, $ 2.1 million was utilized, out of which $2.0million is related to letter of credit issued to one of the customers of one of the Company’s subsidiaries. This line of credit is secured by the accounts receivable, inventory and marketable securities of the relevant subsidiary of the Company. In addition the Company has two automobile purchase loans, of which the later one will be repaid in June 2006. Those loans are denominated in NIS and carry an interest rateof 5.2%-6.2%. Each loan is secured by the automobile purchased with the proceeds of the loan.

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In U.S. dollarsNOTE 10:- PROMISSORY NOTES In connection with the acquisition of IES, the Company issued promissory notes in the face amount of an aggregate of $1,800,000, one of which was a note for $400,000 thatwas convertible into an aggregate of 200,000 shares of the Company’s common stock. The Company has accounted for these notes in accordance with Accounting PrinciplesBoard Opinion No. 21, “Interest on Receivables and Payables,” and recorded the notes at their present value in the amount of $1,686,964. In December 2002, the terms of thesepromissory notes were amended to (i) extinguish the $1,000,000 note due at the end of June 2003 in exchange for prepayment of $750,000, (ii) amend the $400,000 note due atthe end of December 2003 to be a $450,000 note, and (iii) amend the convertible $400,000 note due at the end of June 2004 to be a $450,000 note convertible at $0.75 as to$150,000, at $0.80 as to $150,000, and at $0.85 as to $150,000. In accordance with EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” theterms of promissory notes were not treated as changed or modified as the cash flow effect on a present value basis was less than 10%. The $450,000 note due at the end of June2004 was converted into an aggregate of 563,971 shares of common stock in August 2003. With reference to the $450,000 note due at the end of December 2003, see Note14.f.6.NOTE 11:- OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES

December 31, 2004 2003* Employees and payroll accruals $ 1,534,295 $ 1,232,608 Accrued vacation pay 469,527 216,768 Accrued expenses 1,770,348 842,760 Minority balance 243,116 149,441 Government authorities 1,036,669 357,095 Litigation settlement accrual(1) - 1,163,642 Advances from customers 746,819 - Other 17,414 68,097 $ 5,818,188 $ 4,030,411

* Restated (see Note 1.b.).(1) See Note 14.f.6.NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES a. Royalty commitments: 1. Under EFL’s research and development agreements with the Office of the Chief Scientist (“OCS”), and pursuant to applicable laws, EFL is required to pay royalties at therate of 3%-3.5% of net sales of products developed with funds provided by the OCS, up to an amount equal to 100% of research and development grants received from the OCS(linked to the U.S. dollars. Amounts due in respect of projects approved after year 1999 also bear interest at the Libor rate). EFL is obligated to pay royalties only on sales ofproducts in respect of which OCS participated in their development. Should the project fail, EFL will not be obligated to pay any royalties. Royalties paid or accrued for the years ended December 31, 2004, 2003 and 2002, to the OCS amounted to $17,406, $435 and $32,801, respectively.

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In U.S. dollars NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES (Cont.) As of December 31, 2004, the total contingent liability to the OCS was approximately $10,158,000. The Company regards the probability of this contingency coming to pass inany material amount to be low. 2. EFL, in cooperation with a U.S. participant, has received approval from the Israel-U.S. Bi-national Industrial Research and Development Foundation (“BIRD-F”) for 50%funding of a project for the development of a hybrid propulsion system for transit buses. The maximum approved cost of the project is approximately $1.8 million, and the EFL’sshare in the project costs is anticipated to amount to approximately $1.1 million, which will be reimbursed by BIRD-F at the aforementioned rate of 50%. Royalties at rates of2.5%-5% of sales are payable up to a maximum of 150% of the grant received, linked to the U.S. Consumer Price Index. Accelerated royalties are due under certaincircumstances. EFL is obligated to pay royalties only on sales of products in respect of which BIRD-F participated in their development. Should the project fail, EFL will not be obligated topay any royalties. No royalties were paid or accrued to the BIRD-F in each of the three years in the period ended December 31, 2004. As of December 31, 2004, the total contingent liability to pay BIRD-F (150%) was approximately $772,000. The Company regards the probability of this contingency coming topass in any material amount to be low. b. Lease commitments: The Company and its subsidiaries rent their facilities under various operating lease agreements, which expire on various dates, the latest of which is in 2009. The minimumrental payments under non-cancelable operating leases are as follows:

Year endedDecember 31

2005 $ 762,636 2006 $ 305,109 2007 $ 269,220 2008 $ 66,688 2009 $ 24,312 Total rent expenses for the years ended December 31, 2004, 2003 and 2002 were approximately $868,900, $484,361 and $629,101, respectively. c. Guarantees: The Company obtained bank guarantees in the amount of $1,199,096 in connection with (i) the purchase agreement of one of the Company’s subsidiaries (ii) obligations of twoof the Company’s subsidiaries to the Israeli customs authorities and (iii) obligation of one of the Company’s subsidiaries to secure inventory received from one of its customers.In addition, the Company issued letters o f credit in amounts of $143,895 and $2,000,000 to one of its subsidiary’s suppliers and to one of its subsidiary’s customersrespectively.

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In U.S. dollars NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES (Cont.) d. Liens: As security for compliance with the terms related to the investment grants from the state of Israel, EFL and Epsilor have registered floating liens on all of its assets, in favor ofthe State of Israel. The Company has granted to the holders of its 8% secured convertible debentures a first position security interest in (i) the shares of MDT Armor Corporation, (ii) the assets ofits IES Interactive Training, Inc. subsidiary, (iii) the shares of all of its subsidiaries, and (iv) any shares that the Company acquires in future Acquisitions (as defined in thesecurities purchase agreement). EFL has granted to its former CEO a security interest in certain of its property located in Beit Shemesh, Israel, to secure sums due to him pursuant to the terms of the settlementagreement with him. FAAC has a $3 million line of credit secured by all of its accounts receivable, unbilled revenues and inventory. Epsilor has recorded a lien on all of its assets in favor of its banks to secure lines of credit and loans received. In addition the company has a specific pledge on assets in respectof which government guaranteed loan were given. See also Note 9 regarding automobiles purchased in EFL and Epsilor. e. Litigation and other claims: As of December 31, 2004, there were no pending legal proceedings to which the Company was a party, other than ordinary routine litigation incidental to its business, except asfollows: a. In December 2004, AoA filed an action against a U.S. government defense agency, seeking approximately $2.2 million in damages for alleged improper termination of acontract. In its answer, the government agency counterclaimed, seeking approximately $2.1 million in reprocurement expenses. AoA is preparing its answer to the counterclaim.At this stage in the proceedings, the Company and its legal advisors cannot determine with any certainty whether AoA will have any liability and, if so, the extent of thatliability. b. In the beginning of 2005 a competitor of FAAC brought an action against FAAC and a municipal transport agency, alleging, inter alia, that the municipal transport agencyand FAAC have conspired to violate federal and state antitrust laws and have engaged in unfair competition with respect to this competitor. The competitor seeks unspecifiedmonetary damages from FAAC and the municipal transport agency and injunctive relief. FAAC has not yet filed its answer in this case. At this stage in the proceedings, theCompany and its legal advisors cannot determine with any certainty whether FAAC will have any liability and, if so, the extent of that liability.

F-48


In U.S. dollars NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES (Cont.) c. There is an action against EFL brought in the matter of the bankruptcy of an intellectual property law firm, seeking payment of approximately $150,000, plus interest, feesand costs, in respect of unpaid legal fees and expenses. EFL has not yet filed its answer in this case. The Company and its legal advisors does not believe EFL’s liability in thismatter will exceed $100,000.The Company has recorded an appropriate provision in respect of this amount. d. In 2000 and 2001, the Company sold consumer cellphone batteries and chargers to a major department store chain. Subsequent to these sales, in late 2001, one of theCompany’s employees signed an agreement with the department store chain to price-protect the goods previously sold, with such price protection “to be debited from currentopen invoices.” The department store chain has recently claimed to the Company that the Company owes them approximately $517,000, primarily in respect of this priceprotection. The Company contends that employee who signed the price protection had no authority, actual or apparent, to do so, and that in any event the clear meaning of thelanguage in the price protection is that the department store chain may deduct the price protection from sums they owe the Company, not that the Company is obligated toreturn sums previously paid. Settlement discussions are currently taking place. At this early stage, the Company and its legal advisors cannot determine with any certaintywhether it will have any liability and, if so, the extent of that liability.NOTE 13:- CONVERTIBLE DEBENTURES a. 9% Secured Convertible Debentures due June 30, 2005 Pursuant to the terms of a Securities Purchase Agreement dated December 31, 2002, the Company issued and sold to a group of institutional investors an aggregate principalamount of 9% secured convertible debentures in the amount of $3.5 million due June 30, 2005. These debentures are convertible at any time prior to June 30, 2005 at aconversion price of $0.75 per share, or a maximum aggregate of 4,666,667 shares of common stock. The conversion price of these debentures was adjusted to $0.64 per share inApril 2003. In accordance with EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” the terms of convertible debentures were not treated aschanged or modified when the cash flow effect on a present value basis was less than 10%. As part of the securities purchase agreement on December 31, 2002, the Company issued t o the purchasers of its 9% secured convertible debentures due June 30, 2005,warrants, as follows: (i) Series A Warrants to purchase an aggregate of 1,166,700 shares of common stock at any time prior to December 31, 2007 at a price of $0.84 per share;(ii) Series B Warrants to purchase an aggregate of 1,166,700 shares of common stock at any time prior to December 31, 2007 at a price of $0.89 per share; and (iii) Series CWarrants to purchase an aggregate of 1,166,700 shares of common stock at any time prior to December 31, 2007 at a price of $0.93 per share. The exercise price of thesewarrants was adjusted to $0.64 per share in April 2003. This transaction was accounted according to APB No. 14 “Accounting for Convertible debt and Debt Issued with Stock Purchase Warrants” (“APB No. 14”) and EmergingIssue Task Force No. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments” (“EITF 00-27”). The fair value of these warrants was determined using Black-Scholes pricing model, assuming a risk-free interest rate of 3.5%, a volatility factor 64%, dividend yields of 0% and a contractual life of five years.

F-49


In U.S. dollars NOTE 13:- CONVERTIBLE DEBENTURES (Cont.) In connection with these convertible debentures, the Company recorded a deferred debt discount of $1,890,000 with respect to the beneficial conversion feature and the discountarising from fair value allocation of the warrants according to APB No. 14, which is being amortized from the date of issuance to the stated redemption date - June 30, 2005 - orto the actual conversion date, if earlier, as financial expenses. During 2003, an aggregate principal amount of $2,350,000 in 9% secured convertible debentures was converted into an aggregate of 3,671,875 shares of common stock and anaggregate of 1,500,042 shares were issued pursuant to exercises of the warrants. During 2004, the remaining principal amount of $1,150,000 of 9% secured convertible debentures outstanding was converted into an aggregate of 1,796,875 shares of commonstock. During 2003 and 2004, the Company recorded expenses of $1,517,400 and $372,600, respectively, of which $548,100 and $0, respectively, was attributable to amortization ofthe beneficial conversion feature of the convertible debenture over its term and $969,300 and $372,600, respectively, was attributable to amortization due to conversion of theconvertible debenture into shares. b. 8% Secured Convertible Debentures due September 30, 2006 and issued in September 2003 Pursuant to the terms of a Securities Purchase Agreement dated September 30, 2003, the Company issued and sold to a group of institutional investors an aggregate principalamount of 8% secured convertible debentures in the amount of $5.0 million due September 30, 2006. These debentures are convertible at any time prior to September 30, 2006at a conversion price of $1.15 per share, or a maximum aggregate of 4,347,826 shares of common stock. As part of the securities purchase agreement on September 30, 2003, the Company issued to the purchasers of its 8% secured convertible debentures due September 30, 2006,warrants to purchase an aggregate of 1,250,000 shares of common stock at any time prior to September 30, 2006 at a price of $1.4375 per share. This transaction was accounted according to APB No. 14 “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants” and Emerging Issue Task ForceNo. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.” The fair value of these warrants was determined using Black-Scholes pricing model, assuming arisk-free interest rate of 1.95%, a volatility factor 98%, dividend yields of 0% and a contractual life of three years.

F-50


In U.S. dollars NOTE 13:- CONVERTIBLE DEBENTURES (Cont.) In connection with these convertible debentures, the Company recorded a deferred debt discount of $2,963,043 with respect to the beneficial conversion feature and the discountarising from fair value allocation of the warrants according to APB No. 14, which is being amortized from the date of issuance to the stated redemption date - September 30,2006 - or to the actual conversion date, if earlier, as financial expenses. During 2003, an aggregate principal amount of $3,775,000 in 8% secured convertible debentures was converted into an aggregate of 3,282,608 shares of common stock and anaggregate of 437,500 shares were issued pursuant to exercises of the warrants. During 2004, an aggregate of principal amount $1,075,000 in 8% secured convertible debentures was converted into an aggregate of 934,784 shares. As of December 31, 2004,principal amount of $150,000 remained outstanding under these debentures. During 2003 and 2004, the Company recorded expenses of $2,298,034 and $613,263, respectively, of which $205,858 and $191,895, respectively, was attributable toamortization of the beneficial conversion feature of the convertible debenture over its term and $2,092,176 and $421,368, respectively, was attributable to amortization due toconversion of the convertible debenture into shares. c. 8% Secured Convertible Debentures due September 30, 2006 and issued in December 2003 Pursuant to the terms of a Securities Purchase Agreement dated September 30, 2003, the Company issued and sold to a group of institutional investors an aggregate principalamount of 8% secured convertible debentures in the amount of $6.0 million due September 30, 2006. These debentures are convertible at any time prior to September 30, 2006at a conversion price of $1.45 per share, or a maximum aggregate of 4,137,931 shares of common stock. As a further part of the securities purchase agreement on September 30, 2003, the Company issued to the purchasers of its 8% secured convertible debentures due September30, 2006, warrants to purchase an aggregate of 1,500,000 shares of common stock at any time prior to December 18, 2006 at a price of $1.8125 per share. Additionally, theCompany issued to the investors supplemental warrants to purchase an aggregate of 1,038,000 shares of common stock at any time prior to December 31, 2006 at a price of$2.20 per share. This transaction was accounted according to APB No. 14 “Accounting for Convertible debt and Debt Issued with Stock Purchase Warrants” and Emerging Issue Task Force No.00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.” The fair value of these warrants was determined using Black-Scholes pricing model, assuming a risk-free interest rate of 2.45%, a volatility factor 98%, dividend yields of 0% and a contractual life of three years. In connection with these convertible debentures, the Company recorded a deferred debt discount of $6,000,000 with respect to the beneficial conversion feature and the discountarising from fair value allocation to warrants according to APB No. 14, which is being amortized from the date of issuance to the stated redemption date - September 30, 2006 -or to the actual conversion date, if earlier, as financial expenses. During 2003 the Company recorded an expense of $132,803, which represents the amortization of the beneficial conversion feature of the convertible debenture over its term.

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In U.S. dollars NOTE 13:- CONVERTIBLE DEBENTURES (Cont.) During 2004 an aggregate of 1,500,000 shares were issued pursuant to exercise of these warrants. Out of these warrants, the holders of 1,125,000 warrants exercised theirwarrants on July 14, 2004 were granted an additional warrants to purchase 1,125,000 shares of common stock of the Company at an exercise price per share of $1.38. See alsoNote 14.f.4. During 2004 the Company recorded expenses of $3,156,246 of which $1,782,561 was attributable to amortization of the beneficial conversion feature of the convertibledebenture over its term and $1,373,685 was attributable to amortization due to conversion of the convertible debenture into shares. d. The Company’s debt agreements contain customary affirmative and negative operations covenants that limit the discretion of its management with respect to certain businessmatters and place restrictions on it, including obligations on the Company’s part to preserve and maintain assets and restrictions on its ability to incur or guarantee debt, tomerge with or sell its assets to another company, and to make significant capital expenditures without the consent of the debenture holders, as well as granting to the Company’sinvestors a right of first refusal on any future financings, except for underwritten public offerings in excess of $30 million. Management does not believe that this right of firstrefusal will materially limit the Company’s ability to undertake future financings. NOTE 14:- STOCKHOLDERS’ EQUITY a. Stockholders’ rights: The Company’s shares confer upon the holders the right to receive notice to participate and vote in the general meetings of the Company and right to receive dividends, if andwhen declared. b. Issuance of common stock to investors: 1. On January 18, 2002, the Company issued a total of 441,176 shares of its common stock at a purchase price of $1.70 per share, or a total purchase price of $750,000, to aninvestor (see also Note 14.f.2.). 2. On January 24, 2002, the Company issued a total of 1,600,000 shares of its common stock at a purchase price of $1.55 per share, or a total purchase price of $2,480,000, to agroup of investors. 3. In September 2003, the company acquired an additional 12% interest in MDT Armor Corporation and an additional 24.5% interest in MDT Protective Industries, Ltd. inexchange for the issuance to AGA Means of Protection and Commerce, Ltd. of 126,000 shares of its common stock. 4. In January 2004, the Company issued an aggregate of 9,840,426 shares of common stock at a price of $1.88 per share, or a total purchase price of $18,500,000, to a group ofinvestors (see also Note 14.f.3.). Finance expenses in connection with this issuance totaled $692,500.

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.) 5. In July 2004, pursuant to a Securities Purchase Agreement dated July 15, 2004, the Company issued an aggregate of 4,258,065 shares of common stock at a price of $1.55per share, or a total purchase price of $6,600,000, to a group of investors (see also Note 14.f.4.). c. Issuance of common stock to service providers and employees, in settlement of litigation, and as donations to charities: 1. On February 15, 2002 and September 10, 2002, the Company issued 318,468 and 50,000 shares, respectively, of common stock at par consideration to a consultant forproviding business development and marketing services in the United Kingdom. At the issuance date, the fair value of these shares was determined both by the value of theshares issued as reflected by their market price at the issuance date and by the value of the services provided which amounted to $394,698 and $63,000, respectively, inaccordance with EITF 96-18. In accordance with EITF 96-18, the Company recorded this compensation expense of $394,698 and $63,000, respectively, during the year 2002and included this amount in marketing expenses. 2. On September 10, 2002, the Company issued an aggregate of 13,000 shares of common stock at par consideration to two of its employees as stock bonuses. At the issuancedate, the fair value of these shares was determined by the fair market value of the shares issued as reflected by their market price at the issuance date in accordance with APBNo. 25. In accordance with APB No. 25, the Company recorded this compensation expense of $13,000 during the year 2002 and included this amount in general andadministrative expenses. 3. In July 2003, the Company issued 215,294 shares of common stock to a consultant as commissions on battery orders. At the issuance date, the fair value of these shares wasdetermined both by the value of the shares issued as reflected by the market price at the issuance date and by the value of the services provided and amounted to $154,331 inaccordance with EITF 96-18. In accordance with EITF 96-18, the Company recorded this compensation expense of $154,331 during the year 2003 and included this amount inmarketing expenses. 4. In November 2003, the Company issued 8,306 shares of common stock to a consultant as commissions on battery orders. At the issuance date, the fair value of these shareswas determined by the fair market value of the shares issued as reflected by their market price at the issuance date and by the value of the services provided and amounted to$7,616 in accordance with EITF 96-18. In accordance with EITF 96-18, the Company recorded this compensation expense of $7,616 during the year 2003 and included thisamount in marketing expenses. 5. In February 2004, the Company issued 74,215 shares of common stock to a consultant as commissions on battery orders. At the issuance date, the fair value of these shareswas determined both by the value of the shares issued as reflected by their market price at the issuance date and by the value of the services provided and amounted to $171,680in accordance with EITF 96-18. In accordance with EITF 96-18, the Company accrued this compensation expense of $171,680 during the year 2003 and included this amount inselling and marketing expenses. 6. Beginning in January 2004, the Company entered into a consulting agreement with one of its directors pursuant to which the director agreed to aid the Company in identifyingpotential acquisition candidates, in exchange for a commission. The Company also agreed to issue to this director, at par value, a total of 32,000 shares of its common stock, thevalue of which was to be deducted from any transaction fees paid. 16,000 of these shares were earned and issued prior to termination of this agreement in August 2004. At theissuance date, the fair value of these shares was determined both by the value of the shares issued as reflected by their market price at the issuance date and by the value of theservices provided and amounted to $28,160 in accordance with EITF 96-18. In accordance with EITF 96-18, the Company recorded this compensation expense o f $28,160during the year 2004 and included this amount in general and administrative expenses

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.) 7. In June 2004 the Company sold 40,000 shares of the Company’s common stock at a price of $1.00 per share to one of its employees. At the issuance date, the fair value ofthese shares was determined by the fair market value of the shares issued as reflected by their market price at the issuance date in accordance with APB No. 25. In accordancewith APB No. 25, the Company recorded this compensation expense of $53,200 during the year 2004 and included this amount in general and administrative expenses 8. In December 2004, the Company donated 40,000 shares of its common stock to a charitable organization recognized by the Internal Revenue Service as tax-exempt underSection 501(c)(3) of the Internal Revenue Code of 1986, as amended. At the issuance date, the fair value of these shares was determined by the value of the shares issued asreflected by their market price at the issuance date and amounted to $69,200 in accordance with EITF 96-18. This compensation expense will be amortized over the course ofone year due to legal restrictions on selling these shares for that period of time. In accordance with EITF 96-18, the Company recorded compensation expense of $4,361 duringthe year 2004 and included this amount in general and administrative expenses 9. See Note 14.f.6. d. Issuance of shares to lenders As part of the securities purchase agreement on December 31, 2002 (see Note 13.a.), the Company issued 387,301 shares at par as consideration to lenders for the first ninemonths of interest expenses. At the issuance date, the fair value of these shares was determined both by the value of the shares issued as reflected by their market price at theissuance date and by the value of the interest and amounted to $236,250 in accordance with APB 14. During 2003 the Company recorded this amount as financial expenses. e. Issuance of promissory note: As part of its purchase of the assets of IES Interactive Training, Inc., the Company issued a $450,000 convertible promissory note (see Note 10). This note was converted intoan aggregate of 563,971 shares of common stock in August 2003. f. Warrants: 1. As part of an investment agreement in May 2001, the Company issued to the investors a total of 2,696,971 warrants (the “May 2001 Warrants”) to purchase shares ofcommon stock at a price of $3.22 per share; these warrants are exercisable by the holder at any time after November 8, 2001 and will expire on May 8, 2006.

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.) In June and July 2003, the Company adjusted the purchase price of 1,357,577 of the May 2001 Warrants to $0.82 per share in exchange for immediate exercise of thesewarrants, and issued to the holders of these exercised warrants new warrants to purchase a total of 905,052 shares of common stock at a purchase price of $1.45 per share (the“June 2003 Warrants”). The June 2003 Warrants were originally exercisable at any time from and after December 31, 2003 to June 30, 2008; however, in September 2003, theexercise period of 638,385 of these June 2003 Warrants was adjusted to make them exercisable at any time from and after December 31, 2004 to June 30, 2009. As a result thecompany recorded during 2003 a deemed dividend in the amount of $267,026. See also Note 1.b. I n addition, with respect to an additional 387,879 May 2001 Warrants, in December 2003 the Company adjusted the purchase price to $1.60 per share in exchange forimmediate exercise of these warrants, and issued to the holders of these exercised warrants new warrants to purchase a total of 193,940 shares of common stock at a purchaseprice of $2.25 per share. As a result the company recorded during 2003 a deemed dividend in the amount of $82,974. See also Note 1.b. Additionally, in October 2003 the Company granted to three of these investors additional new warrants to purchase a total of 150,000 shares of common stock at a purchaseprice of $1.20 per share. As a result the company recorded during 2003 an expense of $199,500 and included this amount in general and administrative expenses. During 2004,64,557 warrants were exercised. On July 14, 2004, the Company repriced the exercise price of 242,424 warrants granted previously in May 2001 to $1.88 in order to induce their holders to exercise themimmediately. In connection with the exercise of the warrants, the Company additionally granted five-year warrants to purchase up to an aggregate of 145,454 shares of theCompany’s common stock at an exercise price per share of $1.38. The fair value of these warrants was determined using Black Scholes pricing model, assuming a risk-freeinterest rate of 3.5%, a volatility factor of 79%, dividend yields of 0% and a contractual life of five years. For accounting treatment, please see also Notes 14.b.4. and 14.f.4. 2. As part of the investment agreement in January 2002 (see Note 14.b.1), the Company, in January 2002, issued to a financial consultant that provided investment bankingservices concurrently with this transaction a warrants to acquire (i) 150,000 shares of common stock at an exercise price of $1.68 per share, and (ii) 119,000 shares of commonstock at an exercise price of $2.25 per share; these warrants are exercisable by the holder at any time and will expire on January 4, 2007. 3. In connection with the Securities Purchase Agreement referred to in Note 14.b.4 above, the Company granted three-year warrants to purchase up to an aggregate of 9,840,426shares of the Company’s common stock at any time beginning six months after closing at an exercise price per share of $1.88. In July 2004 an aggregate of 7,446,811 shares were issued pursuant to exercise of these warrants. In connection with the exercise of the warrants, the Company granted to thesame investors five-year warrants to purchase up to an aggregate of 7,446,811 shares of the Company’s common stock at an exercise price per share of $1.38. The fair value ofthese warrants was determined using Black Scholes pricing model, assuming a risk-free interest rate of 3.5%, a volatility factor of 79%, dividend yields of 0% and a contractuallife of five years. See also Note 14.f.4.

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.) 4. On July 14, 2004, warrants to purchase 8,814,235 shares of common stock, having an aggregate exercise price of $16,494,194, net of issuance expenses, were exercised (seealso Notes 14.f.1., 14.f.3. and 13.c.). Out of the shares issued in conjunction with the exercise of these warrants, 1,125,000 shares were issued upon exercise of warrants issuedin the transaction referred to in Note 13.c above and 7,446,811 shares were issued upon exercise of warrants issued in the transaction referred to in the Note 14.f.4. above; theremaining 242,424 shares were issued upon exercise of a warrant that the Company issued to an investor in May 2001 referred to in Note 14.f.1 above. In connection with thistransaction, the Company issued to the holders of those exercising warrants an aggregate of 8,717,265 new five-year warrants to purchase shares of common stock at anexercise price of $1.38 per share As a result of the transactions described in Notes 14 f.1, 14.f.3 and 13.c., including the repricing of the warrants to the investors and the issuance of additional warrants to theinvestors, the Company recorded a deemed dividend in the amount of $2,165,952, to reflect the additional benefit created for these investors. The deemed dividend increased theloss applicable to common stockholders in the calculation of basic and diluted net loss per share for the year ended December 31, 2004, without any effect on total shareholder’sequity. A s all warrants in the July 14, 2004, securities purchase agreement were subject t o shareholders approval, in accordance with Emerging Issues Task Force No.00-19,“Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” their fair value was recorded as a liability at the closing date.Such fair value was remeasured at each subsequent cut-off date. Upon obtaining stockholders approval on December 14, 2004, the warrants were remeasured and reclassified toequity. The fair value of these warrants was determined using the Black-Scholes pricing model, assuming a risk-free interest rate of 3.5%, a volatility factor 79%, dividend yieldsof 0% and a contractual life of approximately five years. The change in the fair value of the warrants between the date of grant and December 14, 2004 has been recorded asfinance income in the amount of $326,839. 5. In November 2000 and May 2001, the Company issued a total of 916,667 warrants to an investor, which warrants contained certain antidilution provisions: a Series Awarrant to purchase 666,667 shares of the Company’s common stock at a price of $3.50 per share, and a Series C warrant to purchase 250,000 shares at a price of $3.08 pershare. Operation of the antidilution provisions provided that the Series A warrant should be adjusted to be a warrant to purchase 888,764 shares at a price of $2.67 per share,and the Series C warrant should be adjusted to be a warrant to purchase 333,286 shares at a price of $2.35 per share. After negotiations, the investor agreed in March 2004 toexercise its warrants immediately, in exchange for an exercise price reduction to $1.45 per share, and the issuance of a new six-month Series D warrant to purchase 1,222,050shares at an exercise price of $2.10 per share. The new Series D warrant does not have similar antidilution provisions. As a result of this repricing and the issuance of newwarrants, the Company recorded a deemed dividend in the amount of approximately $1,163,000 in 2004.

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.) 6. On February 4, 2004, the Company entered into an agreement settling the litigation brought against it in the Tel-Aviv, Israel district court by I.E.S. Electronics Industries, Ltd.(“IES Electronics”) and certain of its affiliates in connection with the Company’s purchase of the assets of its IES Interactive Training, Inc. subsidiary from IES Electronics inAugust 2002. The litigation had sought monetary damages in the amount of approximately $3 million. Pursuant to the terms of the settlement agreement, in addition to agreeingto dismiss their lawsuit with prejudice, IES Electronics agreed (i) to cancel the Company’s $450,000 debt to them that had been due on December 31, 2003, and (ii) to transferto the Company title to certain certificates of deposit in the approximate principal amount of $112,000. The parties also agreed to exchange mutual releases. In consideration ofthe foregoing, the Company issued to IES Electronics (i) 450,000 shares of common stock, and (ii) five-year warrants to purchase up to an additional 450,000 shares ofcommon stock at a purchase price of $1.91 per share. The fair value of the warrants was determined using Black-Scholes pricing model, assuming a risk-free interest rate of3.5%, a volatility factor 79%, dividend yields of 0% and a contractual life of five years. The fair value of warrants was calculated as $483,828 and fair value of shares as$765,000. In respect of the above settlement, the Company recorded in 2003 an expense of $688,642, representing the fair value of the warrants and shares over the remaining balance ofthe Company’s debt to IES Electronics as carried in the Company books at December 31, 2003, less the $112,000 certificate of deposit that was transferred to the Company’sname as noted above. During the year 2004, 200,000 warrants were exercised. 7. As of December 31, 2004, the Company outstanding warrants totaled 16,961,463. g. Stock option and restricted stock purchase plans: 1. Options and restricted shares to employees and others (except consultants) a. The Company has adopted the following stock option plans, whereby options and restricted shares may be granted for purchase of shares of the Company’s common stock.Under the terms of the employee plans, the Board of Directors or the designated committee grants options and determines the vesting period and the exercise terms. 1) 1998 Employee Option Plan - as amended, 4,750,000 shares reserved for issuance, of which no shares were available for future grants to employees and consultants as ofDecember 31, 2004. 2) 1995 Non-Employee Director Plan - 1,000,000 shares reserved for issuance, of which 355,000 were available for future grants to directors as of December 31, 2004. 3) 2004 Employee Option Plan - 7,500,000 shares reserved for issuance, of which 5,168,400 were available for future grants to employees and consultants as of December 31,2004. b. Under these plans, options generally expire no later than 5-10 years from the date of grant. Each option can be exercised to purchase one share, conferring the same rights asthe other common shares. Options that are cancelled or forfeited before expiration become available for future grants. The options generally vest over a three-year period (33.3%per annum) and restricted shares vest after two years; in the event that employment is terminated for cause within that period, restricted shares revert back to the Company.

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.) c. A summary of the status of the Company’s plans and other share options and restricted shares (except for options granted to consultants) granted as of December 31, 2004,2003 and 2002, and changes during the years ended on those dates, is presented below:

2004 2003 2002

Amount

Weightedaverage

exercise price Amount

Weightedaverage


Weightedaverage exercise

price $ $ $ Options outstanding at beginning of year 9,018,311 $ 1.37 5,260,366 $ 2.26 4,240,228 $ 2.74 Changes during year: Granted (1) (2) 2,248,490 $ 1.06 5,264,260 $ 0.71 1,634,567 $ 0.87 Exercised (3) (897,248) $ 1.24 (689,640) $ 0.64 (191,542) $ 1.29 Forfeited (514,793) $ 3.77 (816,675) $ 3.51 (422,887) $ 1.92 Options outstanding at end of year 9,854,760 $ 1.19 9,018,311 $ 1.37 5,260,366 $ 2.26 Options exercisable at end of year 6,465,316 $ 1.32 5,826,539 $ 1.70 4,675,443 $ 2.26

(1) Includes 936,250, 2,035,000 and 481,435 options and restricted shares granted to related parties in 2004, 2003 and 2002, respectively.

(2) The Company recorded deferred stock compensation for options and restricted shares issued with an exercise price below the fair value of the common stock in theamount of $2,081,457, $4,750 and $0 as of December 31, 2004, 2003 and 2002, respectively. Deferred stock compensation is amortized and recorded as compensationexpenses ratably over the vesting period of the option or the restriction period of the restricted shares. The stock compensation expense that has been charged in theconsolidated statements of operations in respect of options and restricted shares to employees and directors in 2004, 2003 and 2002, was $831,626, $8,286 and $6,000,respectively.

(3) In June 2002, the employees exercised 100,000 options for which the exercise price was not paid at the exercise date. The Company recorded the owed amount of$73,000 as “Note receivable from stockholders” in the Statement of Changes in Stockholders’ Equity. In accordance with EITF 95-16, since the original option grant didnot permit the exercise of the options through loans, and due to the Company’s history of granting non-recourse loans, this postponement in payments of the exerciseprice resulted in a variable plan accounting. However, the Company did not record any compensation due to the decrease in the market value of the Company’s sharesduring 2002. During 2002 the note in the amount of $36,500 was forgiven and appropriate compensation was recorded. During 2003 and 2004, the Company recordedcompensation expenses and (income) in amounts of $38,500 and ($10,000), respectively, due to increase and decrease in the market value of the Company’s shares.

d. The options and restricted shares outstanding as of December 31, 2004 have been separated into ranges of exercise price, as follows:

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.)

Total options outstanding Exercisable options outstanding

Range ofexerciseprices

Amount

outstanding atDecember 31,

2004

Weightedaverage

remainingcontractual life

Weightedaverage

exercise price

Amountexercisable at

December 31, 2004

Weightedaverage

exercise price $ Years $ $

0.01-2.00 8,944,827 6.44 0.87 5,730,382 0.88 2.01-4.00 270,933 3.79 2.46 95,934 2.56 4.01-6.00 594,000 1.97 4.80 594,000 4.80 6.01-8.00 35,000 1.05 7.73 35,000 7.73 8.01 10,000 2.75 9.06 10,000 9.06 9,854,760 6.07 1.19 6,465,316 1.32 Weighted-average fair values and exercise prices of options and restricted shares on dates of grant are as follows: Equals market price Less than market price Year ended December 31, Year ended December 31, 2004 2003 2002 2004 2003 2002

Weighted average exercise prices $ 1.494 $ 0.950 $ 1.265 $ 1.672 $ - $ 0.755 Weighted average fair value on grant date $ 1.002 $ 0.730 $ 0.560 $ 1.729 $ - $ 0.250

2. Options issued to consultants: a. The Company’s outstanding options to consultants as of December 31, 2004, are as follows: 2004 2003 2002

Amount

Weightedaverage


Weightedaverage


Weightedaverage

exercise price $ $ $

Options outstanding at beginning of year 313,901 $ 4.59 245,786 $ 5.55 245,786 $ 5.55 Changes during year:

Granted 10,000 $ - 83,115 $ 0.99 - $ - Exercised (37,615) $ 1.03 (15,000) $ 0.49 - $ - Forfeited or cancelled (120,000) $ 6.40 - $ - - $ -

Options outstanding at end of year 166,286 $ 3.80 313,901 $ 4.59 245,786 $ 5.55

Options exercisable at end of year 166,286 $ 3.80 193,901 $ 3.46 125,786 $ 6.42

b. The Company accounted for its options to consultants under the fair value method of SFAS No. 123 and EITF 96-18. The fair value for these options was estimated using aBlack-Scholes option-pricing model with the following weighted-average assumptions:

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In U.S. dollars NOTE 14:- STOCKHOLDERS’ EQUITY (Cont.) 2004 2003 2002Dividend yield 0% 0% -Expected volatility 81% 78% -Risk-free interest 3.4% 2.3% -Contractual life of up to 5 years 10 years -

c. In connection with the grant of stock options to consultants, the Company recorded stock compensation expenses totaling $0, $29,759 and $0 for the years ended December31, 2004, 2003 and 2002, respectively, and included these amounts in marketing and general and administrative expenses. 3. Dividends: In the event that cash dividends are declared in the future, such dividends will be paid in U.S. dollars. The Company does not intend to pay cash dividends in the foreseeablefuture. 4. Treasury Stock: Treasury stock is the Company’s common stock that has been issued and subsequently reacquired. The acquisition of common stock is accounted for under the cost method, andpresented as reduction of stockholders’ equity. NOTE 15:- INCOME TAXES a. Taxation of U.S. parent company (Arotech) and other U.S. subsidiaries: As of December 31, 2004, Arotech has operating loss carryforwards for U.S. federal income tax purposes of approximately $23 million, which are available to offset futuretaxable income, if any, expiring in 2009 through 2024. Utilization of U.S net operating losses may be subject to substantial annual limitations due to the “change in ownership”provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating loses before utilization. The Company files consolidated tax returns with its US subsidiaries. b. Israeli subsidiary (Epsilor): Tax benefits under the Law for the Encouragement of Capital Investments, 1959 (the “Investments Law”): Currently, Epsilor is operating under three programs as follows: 1. Program one: Epsilor’s expansion program of its existing enterprise in Dimona was granted the status of an “approved enterprise” under the Investments Law and was entitled to investmentsgrants from the state of Israel in the amount of 24% on property and equipment located at its Dimona plant. The approved expansion program was in the amount of approximately $350,000. Epsilor effectively operated the program during 1999 and is entitled to the tax benefits availableunder the Investments Law.

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In U.S. dollars NOTE 15:- INCOME TAXES (Cont.) Taxable income derived from the approved enterprise is subject to a reduced tax rate during seven years beginning from the year in which taxable income is first earned (taxexemption for the first two-year period and 25% tax rate for the five remaining years). Those benefits are limited to 12 years from the year that the enterprise began operations, or 14 years from the year in which the approval was granted, whichever is earlier.Hence, this approved program will expire in 2005. 2. Program two: Epsilor’s expansion program of its existing enterprise in Dimona was granted the status of an “approved enterprise” under the Investments Law and was entitled to investmentsgrants from the State of Israel in the amount of 24% on property and equipment located at its Dimona plant. The approved expansion program is in the amount of approximately $600,000. Epsilor effectively operated the program during 2002, and is entitled to the tax benefits availableunder the Investments Law (commencing from 2003). Taxable income derived from the approved enterprise is subject to a reduced tax rate during seven years beginning from the year in which taxable income is first earned (taxexemption for the first two-year period and 25% tax rate for the five remaining years). Those benefits are limited to 12 years from the year that the enterprise began operations, or 14 years from the year in which the approval was granted, whichever is earlier.Hence, this approved program will expire in 2009. 3. Program three: Epsilor’s expansion program of its existing enterprise in Dimona was granted the status of an “approved enterprise” under the Investments Law, and is entitled to investmentsgrants from the State of Israel in the amount of 32% on property and equipment located at its Dimona plant. The approved expansion program is in the amount of approximately $945,000. This program has not yet received final approval. Taxable income derived from the approved enterprise is subject to a reduced tax rate during seven years beginning from the year in which taxable income is first earned (taxexemption for the first two-year period and 25% tax rate for the five remaining years). Those benefits are limited to 12 years from the year that the enterprise began operations, or 14 years from the year in which the approval was granted, whichever is earlier. The main tax benefits available to Epsilor are: a) Reduced tax rates: As stated above for each specific program b) Accelerated depreciation: Epsilor is entitled to claim accelerated depreciation in respect of machinery and equipment used by the “Approved Enterprise” for the first five years of operation of these assets.

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In U.S. dollars NOTE 15:- INCOME TAXES (Cont.) Income from sources other than the “Approved Enterprise” during the benefit period will be subject to tax at the regular corporate tax rate of 35%. . If retained tax-exempt profits attributable to the “approved enterprise” are distributed, they would be taxed at the corporate tax rate applicable to such profits as if Epsilor hadnot elected the alternative system of benefits, currently 25% for an “approved enterprise.” Dividends paid from the profits of an approved enterprise are subject to tax at the rate of 15% in the hands of their recipient. As of December 31, 2004 approximately $370,000 were derived from tax exempt profits earned by Epsilor’s “approved enterprises”; by Israeli law, the Company can distributeonly $197,000 of this amount. The Company has determined that such tax exempt income in the amount of $180,000 will not be distributed as dividends. Tax liability on what can be distributed as dividends from these tax exempt profits and other Epsilor profits in 2004 in the hand of the recipient and on the company level asstated in previous section is $51,000 and accordingly deferred tax liability was recorded as of December 31, 2004. c. Israeli subsidiary (EFL): 1. Tax benefits under the Investments Law: A small part of EFL’s manufacturing facility has been granted “Approved Enterprise” status under the Investments Law, and was entitled to investment grants from the State ofIsrael of 38% on property and equipment located in Jerusalem, and 10% on property and equipment located in its plant in Beit Shemesh, and to reduced tax rates on incomearising from the “Approved Enterprise,” as detailed below. The period of tax benefits granted by “Approved enterprise” is subject to limits of 12 years from the commencement of production, or 14 years from the approval date,whichever is earlier. The approved program expired in 2004. The benefits were not utilized since the Company had no taxable income, since its incorporation. d. Other tax information about the Israeli subsidiaries: 1. Measurement of results for tax purposes under the Income Tax Law (Inflationary Adjustments), 1985 Results for tax purposes are measured in real terms of earnings in NIS after certain adjustments for increases in the Consumer Price Index. As explained in Note 2.b., thefinancial statements are presented in U.S. dollars. The difference between the annual change in the Israeli consumer price index and in the NIS/dollar exchange rate causes adifference between taxable income and the income before taxes shown in the financial statements. In accordance with paragraph 9(f) of SFAS No. 109, EFL, Epsilor and MDThave not provided deferred income taxes on this difference between the reporting currency and the tax bases of assets and liabilities.

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In U.S. dollars NOTE 15:- INCOME TAXES (Cont.) 2. Tax benefits under the Law for the Encouragement of Industry (Taxation), 1969: EFL and Epsilor are “industrial companies,” as defined by this law and, as such, are entitled to certain tax benefits, mainly accelerated depreciation, as prescribed by regulationspublished under the inflationary adjustments law, the right t o claim amortization of know-how, patents and certain other intangible property rights as deductions for taxpurposes. 3. Tax rates applicable to income from other sources: Income from sources other than the “Approved Enterprise,” is taxed at the regular rate of 35%. See also Note 15.e 4. Tax loss carryforwards: As of December 31, 2004, EFL has operating and capital loss carryforwards for Israeli tax purposes of approximately $87.0 million, which are available, indefinitely, to offsetfuture taxable income. e. Reduction in corporate tax rate In June 2004, the Israeli Parliament approved an amendment to the Income Tax Ordinance (No. 140 and Temporary Provision) (the “Amendment”), which progressivelyreduces the corporate tax rate from 36% to 35% in 2004 and to a rate of 30% in 2007. The amendment was signed and published in July 2004 and is, therefore, consideredenacted in July 2004. As the Company currently has no taxable income, and no deferred taxes were recorded, the amendment does not have an impact on the Company’s resultsof operation or financial position. f. Deferred income taxes: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amountsused for income tax purposes. Significant components of the Company’s deferred tax assets resulting from tax loss carryforward are as follows: December 31, 2004 2003

Operating loss carryforward $ 32,532,998 $ 33,958,434 Reserve and allowance 1,328,479 843,453

Net deferred tax asset before valuation allowance 33,861,477 34,801,887 Valuation allowance (33,725,995) (34,801,887)

Total deferred tax asset $ 135,482 $ - Deferred tax liability $ 51,366 $ -

The Company and its subsidiaries provided valuation allowances in respect of deferred tax assets resulting from tax loss carryforwards and other temporary differences.Management currently believes that it is more likely than not that the deferred tax assets related to the loss carryforwards and other temporary differences will not be realized.The change in the valuation allowance as of December 31, 2004 was $1,075,892

F-63


In U.S. dollars NOTE 15:- INCOME TAXES (Cont.) g. Loss from continuing operations before taxes on income and minorities interests in loss (earnings) of a subsidiary: Year ended December 31 2004 2003* 2002** Domestic $ 8,006,205 $ 7,411,121 $5,250,633Foreign 405,305 1,697,617 13,253,725 $ 8,411,510 $ 9,108,738 $18,504,358

* Restated (see Note 1.b.).** Includes loss from discontinued operations and minority interest in loss (earnings) of a subsidiary

h. Taxes on income were comprised of the following: Year ended December 31 2004 2003 2002

Current state and local taxes $ 539,674 $ 44,102 $ - Deferred taxes (37,857) - - Taxes in respect of prior years 84,292 352,091 -

$ 586,109 $ 396,193 $ -

Domestic $ 163,087 $ 33,020 $ - Foreign 423,022 363,173 -

$ 586,109 $ 396,193 $ -

i. The cumulative amount of undistributed earnings of foreign subsidiaries, which is intended to be permanently reinvested and for which U.S. income taxes have not beenprovided, totaled approximately $180,000 and $0 on December 31, 2004 and 2003 respectively. j. A reconciliation between the theoretical tax expense, assuming all income is taxed at the statutory tax rate applicable to income of the Company and the actual tax expense asreported in the Statement of Operations is as follows:

F-64


In U.S. dollars NOTE 15:- INCOME TAXES (Cont.) Year ended December 31, 2004 2003* 2002

Loss from continuing operations before taxes, as reported in the consolidated statements ofincome $ (8,411,510) $ (9,108,738) $ (4,582,792)

Statutory tax rate 34% 34% 34%

Theoretical income tax on the above amount at the U.S. statutory tax rate $ (2,859,914) $ (3,096,971) $ (1,558,149)Deferred taxes on losses for which valuation allowance was provided 556,692 1,146,754 1,558,149 Non-deductible expenses 1,629,874 1,873,129 - State taxes 168,081 33,020 - Accrual for deferred taxes on undistributed earnings 49,416 - - Foreign income in tax rates other then U.S rate 919,895 86,954 - Taxes in respect of prior years 84,292 352,091 - Others 37,773 1,216 -

Actual tax expense $ 586,109 $ 396,193 $ -

* Restated (see Note 1.b.). NOTE 16:- SELECTED STATEMENTS OF OPERATIONS DATA Financial income (expenses), net: Year ended December 31, 2004 2003* 2002 Financial expenses: Interest, bank charges and fees $ (622,638) $ (355,111) $ (89,271)Amortization of compensation related to warrants issued to the holders of convertible debentures

and beneficial conversion feature (4,142,109) (3,928,237) - Bonds premium amortization (202,467) - - Foreign currency translation differences (71,891) 115,538 15,202 (5,039,105) (4,167,810) (74,069)Financial income:

Interest 443,182 129,101 174,520 Realized gain from marketable securities sale 40,119 - - Financial income in connection with warrants granted (note 14.f.4) 326,839 - -

Total $ (4,228,965) $ (4,038,709) $ 100,451


F-65


In U.S. dollars NOTE 17:- RELATED PARTY DISCLOSURES Year ended December 31, 2004 2003 2002

Transactions:

Reimbursement of general and administrative expenses - - $ 36,000

Financial income (expenses), net from notes receivable and loan holders $ 18,251 - $ (7,309)

NOTE 18:- SEGMENT INFORMATION a. General: The Company and its subsidiaries operate primarily in three business segments (see Note 1.a. for a brief description of the Company’s business) and follow the requirements ofSFAS No. 131. Prior to its purchase of FAAC, Epsilor and AoA, the Company had managed its business in two reportable segments organized on the basis of differences in its related productsand services. With the acquisition of FAAC and Epsilor early in 2004 and AoA in August of 2004, the Company reorganized into three segments: Simulation and Security;Armor; and Battery and Power Systems. As a result the Company restated information previously reported in order to comply with new segment reporting. The Company’s reportable operating segments have been determined in accordance with the Company’s internal management structure, which is organized based on operatingactivities. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies. The Company evaluatesperformance based upon two primary factors, one is the segment’s operating income and the other is based on the segment’s contribution to the Company’s future strategicgrowth. b. The following is information about reported segment gains, losses and assets:

Simulation andSecurity Armor

Battery andPower Systems All Others(4) Total

2004 Revenues from outside customers $ 21,464,406 $ 17,988,687 $ 10,500,753 $ - $ 49,953,846 Depreciation expenses and amortization (1) (1,983,822) (1,755,847) (1,132,953) (135,613) (5,008,235)Direct expenses (2) (17,910,967) (16,444,476) (9,974,544) (5,431,627) (49,761,614)Segment net income (loss) $ 1,569,617 $ (211,636) $ (606,744) $ (5,567,240) (4,816,003)Financial expenses (after deduction of minority interest) (4,226,310)Net loss from continuing operations $ (9,042,313)

Segment assets (3) $ 1,872,943 $ 5,819,266 $ 3,455,188 $ 730,595 $ 11,877,992

F-66


In U.S. dollars NOTE 18:- SEGMENT INFORMATION (Cont.)

Simulation andSecurity Armor

Battery andPower Systems All Others(4) Total

2003* Revenues from outside customers $ 8,022,026 $ 3,435,716 $ 5,868,899 $ - $ 17,326,641 Depreciation expenses and amortization (757,997) (169,668) (527,775) (139,630) (1,595,070)Direct expenses (2) (7,308,649) (3,584,284) (5,945,948) (4,200,770) (21,039,651)Segment net income (loss) $ (44,620) $ (318,236) $ (604,824) $ (4,340,400) (5,308,080)Financial expenses (after deduction of minority interest) (4,039,951)Net loss from continuing operations $ (9,348,031)

Segment assets (3) $ 898,271 $ 730,291 $ 2,128,062 $ 450,864 $ 4,207,488 2002 Revenues from outside customers $ 1,980,061 $ 2,744,382 $ 1,682,296 $ - $ 6,406,739 Depreciation expenses and amortization (1) (569,832) (106,921) (252,514) (194,014) (1,123,281)Direct expenses (1) (2,037,775) (2,315,995) (3,062,548) (2,905,743) (10,322,061)Segment net income (loss) $ (627,546) $ 321,466 $ (1,632,766) $ (3,099,757) (5,038,603)Financial income (after deduction of minority interest) 100,451 Net income from continuing operations $ (4,938,152)

Segment assets (3) $ 655,143 $ 1,028,682 $ 2,007,291 $ 575,612 $ 4,266,728

* Restated (see Note 1.b.).(1) Including property and equipment depreciation, intangible assets amortization and amortization of adjustment of one of the Company’s subsidiaries’ inventory to marketvalues as of the purchase date.(2) Including sales and marketing, general and administrative expenses.(3) Including property and equipment and inventory.(4) Including unallocated costs. The Company allocates its goodwill among its three divisions as follows: Year ended December 31, 2004 2003 2002 Simulation and Security Division $ 22,845,372 $ 4,032,726 $ 4,068,726 Armor Division $ 11,591,228 $ 1,031,829 $ 886,255 Battery and Power Systems Division

$ 5,308,916 $ - $ - c. Summary information about geographic areas:

F-67


In U.S. dollars NOTE 18:- SEGMENT INFORMATION (Cont.) The following presents total revenues according to end customers location for the years ended December 31, 2004, 2003 and 2002, and long-lived assets as of December 31,2004, 2003 and 2002: 2004 2003 2002

Totalrevenues

Long-livedassets

Totalrevenues

Long-livedassets

Totalrevenues

Long-livedassets

U.S. dollars U.S.A. $ 40,656,729 $ 45,154,086 $ 10,099,652 $ 6,778,050 $ 2,787,250 $ 6,710,367 Germany 319,110 - 2,836,725 - 38,160 - England 344,261 - 29,095 - 47,696 - Thailand - - 95,434 - 291,200 - India 3,061,705 - - - - - Israel 4,212,408 13,560,822 3,576,139 2,954,441 2,799,365 3,367,320 Other 1,359,633 - 689,596 - 443,068 - $ 49,953,846 $ 58,714,908 $ 17,326,641 $ 9,732,491 $ 6,406,739 $ 10,077,687

d. Revenues from major customers: Year ended December 31, 2004 2003 2002 %Batteries and power systems:

Customer A 8% 27% 8%Armor:

Customer B 4% 17% 43%Customer C 24% - -

Simulation and security: Customer D 13% - -Customer E 1% 16% -

e. Revenues from major products: Year ended December 31, 2004 2003 2002 Electric - vehicle $ 232,394 $ 408,161 $ 460,562 Water activated batteries 921,533 703,084 647,896 Military batteries 9,324,247 4,757,116 573,839 Car armoring 17,988,686 3,435,715 2,744,382 Simulators 21,414,968 7,961,302 1,980,060 Other 72,018 61,263 - Total $ 49,953,846 $ 17,326,641 $ 6,406,739

F-68

SUPPLEMENTARY FINANCIAL DATA

Quarterly Financial Data (unaudited) for the two years ended December 31, 2004

Quarter Ended* 2004 March 31 June 30 September 30 December 31

Net revenue $ 7,182,254 $ 9,928,248 $ 16,272,521 $ 16,570,823 Gross profit $ 2,625,034 $ 3,353,501 $ 4,723,573 $ 5,240,644 Net profit (loss) from continuing operations $ (2,517,889) $ (4,396,123) $ 1,126,845 $ (3,255,146)Net loss from discontinued operations $ - $ - $ - $ - Net profit (loss) for the period $ (2,517,889) $ (4,396,123) $ 1,126,845 $ (3,255,146)Deemed dividend to certain stockholders of common stock $ (1,163,000) $ - $ (2,165,952) $ - Net loss attributable to common stockholders $ (3,680,889) $ (4,396,123) $ (1,039,107) $ (3,255,146)Net profit (loss) per share - basic and diluted $ (0.06) $ (0.07) $ (0.01) $ (0.04)Shares used in per share calculation 59,406,466 64,499,090 76,744,251 79,075,181

Quarter Ended 2003* March 31 June 30 September 30 December 31

Net revenue $ 4,033,453 $ 3,493,135 $ 5,705,898 $ 4,094,155 Gross profit $ 1,399,734 $ 1,013,965 $ 2,453,575 $ 1,371,527 Net loss from continuing operations $ (1,291,122) $ (2,788,348) $ 218,606 $ (5,487,167)Net income (loss) from discontinued operations $ (95,962) $ 179,127 $ (2,285) $ 29,529 Net income (loss) for the period $ (1,387,083) $ (2,609,221) $ 216,321 $ (5,457,638)Deemed dividend to certain stockholders of common stock $ - $ (172,350) $ (94,676) $ (82,974)Net income (loss) attributable to common stockholders $ (1,387,083) $ (2,781,571) $ 121,645 $ (5,540,612)Net loss per share - basic and diluted $ (0.04) $ (0.08) $ 0.00 $ (0.13)Shares used in per share calculation 34,758,960 36,209,872 40,371,940 43,604,830

* Restated (see Note 1.b. of Notes to Consolidated Financial Statements).

F-69

FINANCIAL STATEMENT SCHEDULE

Arotech Corporation and Subsidiaries

Schedule II - Valuation and Qualifying Accounts

For the Years Ended December 31, 2004, 2003 and 2002

Description

Balance atbeginningof period

Additionscharged tocosts andexpenses

Balance atend ofperiod

Year ended December 31, 2004 Allowance for doubtful accounts $ 61,282 $ (5,888) $ 55,394 Allowance for slow moving inventory 96,350 121,322 217,672 Valuation allowance for deferred taxes 34,801,887 (1,075,892) 33,725,995 Totals $ 34,959,519 $ (960,458) $ 33,999,061

Year ended December 31, 2003 Allowance for doubtful accounts $ 40,636 $ 20,646 $ 61,282 Allowance for slow moving inventory - 96,350 96,350 Valuation allowance for deferred taxes 29,560,322 5,241,565 34,801,887 Totals $ 29,600,958 $ 5,358,561 $ 34,959,519

Year ended December 31, 2002 Allowance for doubtful accounts $ 39,153 $ 1,483 $ 40,636 Valuation allowance for deferred taxes 12,640,103 16,920,219 29,560,322 Totals $ 12,679,256 $ 16,921,702 $ 29,600,958

F-70

Exhibit Index

ExhibitNumber

Description

23.1

Consent of Kost, Forer, Gabbay & Kassierer, a member of Ernst & Young Global

23.2

Consent of Stark Winter Schenkein & Co., LLP

31.1

Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2

Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 31.1

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Robert S. Ehrlich, certify that:

1. I have reviewed this amended annual report on Form 10-K/A of Arotech Corporation;

2. Based on my knowledge, this amended annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this amended annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this amended annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this amended annual report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this amended annual report is being prepared;

(b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this amended annual report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this amended annual report based on such evaluation (the "Evaluation Date"); and

(d) disclosed in this amended annual report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of this amended annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: August 15, 2005 /s/ Robert S. Ehrlich --------------------------------------------------- Robert S. Ehrlich, Chairman, President and CEO (Principal Executive Officer)

Exhibit 31.2

CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Avihai Shen, certify that:

1. I have reviewed this amended annual report on Form 10-K/A of Arotech Corporation;

2. Based on my knowledge, this amended annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this amended annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this amended annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this amended annual report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this amended annual report is being prepared;

(b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this amended annual report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this amended annual report based on such evaluation (the "Evaluation Date"); and

(d) disclosed in this amended annual report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of this amended annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: August 15, 2005 /s/ Avihai Shen --------------------------------------------- Avihai Shen, Vice President - Finance and CFO (Principal Financial Officer)

Exhibit 32.1

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the amended Annual Report of Arotech Corporation(the "Company") on Form 10-K/A for the year ended December 31, 2004 filed withthe Securities and Exchange Commission (the "Report"), I, Robert S. Ehrlich,Chairman, President and Chief Executive Officer of the Company, pursuant to 18U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-OxleyAct of 2002, hereby certify that the Report fully complies with the requirementsof Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and theinformation contained in the Report fairly presents, in all material respects,the financial condition and results of operations of the Company.

By: /s/ Robert S. Ehrlich ----------------------------------------------- Robert S. Ehrlich, Chairman, President and CEO (Chief Executive Officer)

Date: August 15, 2005

CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the amended Annual Report of Arotech Corporation(the "Company") on Form 10-K/A for the year ended December 31, 2004 filed withthe Securities and Exchange Commission (the "Report"), I, Avihai Shen, VicePresident - Finance and Chief Financial Officer of the Company, pursuant to 18U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-OxleyAct of 2002, hereby certify that the Report fully complies with the requirementsof Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and theinformation contained in the Report fairly presents, in all material respects,the financial condition and results of operations of the Company.

By: /s/ Avihai Shen --------------------------------------------------- Avihai Shen, Vice President - Finance and CFO (Chief Financial Officer)

Date: August 15, 2005